DBRS Clarifies Notching Policy for Rating Secured Leveraged Loans

DBRS has today released an updated methodology that provides a refinement of its leveraged finance ratings criteria to limit the notching-up of ratings for the secured debt of high-yield issuers that are just below the investment-grade level and have a strong recovery rating. Under the revised policy, the result of any notch-up of the instrument rating for a high-yield issuer will be limited to an instrument rating of BBB (low), regardless of the level of the recovery rating that may have been assigned to the instrument.

In assigning ratings to leveraged finance (i.e., high-yield) issues, DBRS first assigns an issuer rating that reflects the default risk of the issuer itself, then assigns separate recovery ratings and instrument ratings to the issuer’s specific debt instruments. The instrument rating is a blend of both the issuer rating and the recovery rating and, therefore, may be notched up from the issuer rating in cases where the recovery rating reflects above-average post-default recovery prospects. Likewise, the instrument rating may be notched down in cases where the recovery rating reflects diminished recovery prospects.

The likelihood of default is more remote for investment-grade issuers, which is why DBRS only assigns recovery ratings to non-investment-grade issuers. The effect of this policy refinement is to lessen the weighting of recovery on the instrument ratings of non-investment-grade credits that are on the cusp of becoming investment grade. DBRS believes – and empirical data demonstrates – that default is a substantial possibility for issuers in the B category and below; therefore, the recovery outlook should weigh relatively heavily on the instrument rating. As a company moves through the BB range and approaches investment grade, the likelihood of default is significantly less, and it is appropriate to restrict the beneficial impact of the recovery rating on the final instrument rating outcome.

This policy change has resulted in rating changes to two issuers, Domtar Corporation and Sears Canada Inc. (see the separate press releases published today). DBRS notes that because both of these changes reflect a change in methodology, they are considered technical in nature and in no way reflect any DBRS change of opinion on the credit quality of the issuers. All other ratings for both issuers remain unchanged.

The methodology providing DBRS's processes and criteria is available by contacting us at info@dbrs.com.