Credit Ratings for Preferred Stocks: Agency Methodologies

Credit rating agencies do not evaluate preferred stock the way they evaluate senior debt from the same issuer, and the distinction matters more for this asset class than for almost any other segment of the fixed-income market. The three major agencies — Moody's, S\&P Global Ratings, and Fitch — each apply what is generally termed "notching" to subordinated securities. A company's preferred stock will typically be rated one to three notches below its senior unsecured debt rating, reflecting both its lower priority in the capital structure and the discretionary nature of its dividend payments. A company rated A- on its senior debt might see its preferred stock rated BBB or lower, even though both securities are issued by the same entity with the same underlying business risk. The notching is not an inconsistency; it is the methodology working as designed, pricing the difference in expected loss between two claims on one enterprise. The width of the notching gap varies systematically. For investment-grade industrial issuers, two notches below the senior rating is a common convention. For issuers with elevated leverage, or those rated below investment grade, agencies often widen the gap, reasoning that the probability of a dividend deferral rises disproportionately as overall credit quality declines. Structural features matter as well: non-cumulative dividends, deep subordination, and provisions that permit deferral without consequence all argue for wider notching, since agencies weigh the practical likelihood that a payment could be skipped without triggering the broader consequences a missed bond payment would carry. Financial institutions present a further layer. Banks issue preferred stock structured to qualify as regulatory capital, and those structures are designed, at the insistence of regulators, to absorb losses while the institution continues operating. Agencies apply additional scrutiny, and additional notches, to these loss-absorption features, which is why the preferred stock of even the largest and most familiar banks frequently carries a rating at the lowest rung of investment grade or below it. A related nuance deserves mention: agencies often assign hybrid securities partial "equity credit" when assessing the issuer's own leverage, treating the preferred as part debt and part equity for the purpose of the issuer's rating, even as they rate the security itself several notches down. Investors should also be prepared for the substantial portion of the exchange-traded market that carries no rating at all. Many baby bonds and preferreds from smaller issuers, business development companies, and specialty finance firms are unrated, not necessarily because the credit is poor, but because the issuer declined to pay for coverage of a retail-oriented issue. An unrated security demands independent analysis; it neither deserves the benefit of the doubt nor warrants automatic exclusion. Split ratings, where two agencies disagree by a notch or more, are likewise common in this market and often mark securities where reasonable analysts differ, which can be a source of value for investors willing to do the work. Ratings also move slowly by design, and the market frequently reprices a security well before an agency acts. A preferred trading at a yield far wider than its rating category suggests is conveying information; the investor's task is to determine whether the market or the agency has the better argument. Downgrades from investment grade to high yield, which force selling by rating-constrained funds, can create pronounced dislocations in preferred securities, historically among the more fertile hunting grounds for patient buyers. For an income investor, the practical implications are threefold. First, the issuer's senior rating cannot be applied to its preferred stock without adjustment; the security's own rating, where one exists, is the relevant figure. Second, the rating should be read alongside the measures that drive it: earnings coverage of fixed charges, leverage, and, for financial issuers, regulatory capital ratios. Third, ratings are an input, not a verdict. They compress a committee's judgment into a letter grade, and the letter grade omits the security-specific provisions, call structures, and market technicals that frequently matter as much as the credit itself.