What Is a Downgrade?

A downgrade is a negative change in the rating of a stock's expected performance, issued by an analyst for a financial services firm. The analyst is indicating that the company's future prospects have weakened.

Many financial services firms employ analysts to provide research to their clients, including rating stocks with a buy, hold, or sell rating. A downgrade would change an analyst's rating from a buy to a hold, or from a hold to a sell. An upgrade is a move in the opposite direction.

Debt has its own rating system. One of several ratings agencies assigns letter grades to debt based on an evaluation of the company's ability to repay those debts. When a bond is downgraded, it might move from an "A" rating to a "BBB" rating.

How Downgrades Work

Analysts place recommendations on stocks to give their clients or investors a general idea of the expected performance of that security looking forward. The recommendations are adjusted when the basis behind the recommendation changes. Reasons for a downgrade or an upgrade might be:

• A major announcement by the company
• Unexpected numbers in its financial statements
• A news event that has repercussions for the company or its industry
• A change in management, a board of directors
• New government regulations that impact the business or industry
• Changes in government control or the behavior of government officials

Bond Downgrades

In the case of bonds, there are several rating agencies whose sole responsibility is to research debt issuers and assign ratings to their various types of debt. The major bond-rating agencies are are Standard & Poor's Global Ratings, Fitch Ratings, and Moody's.

Moving from a "BBB" rating, which is investment grade, to "BB," which is below investment grade, can have severe effects on the price and prospects of a company or government that issued the bonds. A rating below investment grade indicates deteriorating fundamentals in the issuing company or government.

Reasons for Downgrade

An analyst may downgrade a stock from a buy to a sell after the issuing company releases information about a Securities and Exchange Commission (SEC) investigation into the company's operations. A stock may also be downgraded because of deteriorating fundamentals of the issuing company, or because the current marketplace or macro-environment has taken an unfavorable turn. For stocks and bonds, a downgrade generally leads to negative media coverage. Behind the scenes, the biggest drawback to a downgrade is a higher cost of capital, for both debt and equity.

Warning Signs of a Downgrade

Credit rating agencies and stock analysts both publish watchlists indicating stocks or companies that are at risk of a downgrade. Investors and creditors keep a close eye on these lists. A downgrade or an upgrade may be accompanied by a prediction for a specific target price that the stock is expected to hit. For example, an analyst might downgrade a stock from "buy" to "hold" and attach a target price that represents a 2.5% decline. If the analyst is closely followed, the stock will decline in price by 2.5% in the hours after that announcement.

The Bottom Line

A downgrade happens when the outlook for a stock or a bond changes negatively. Downgrades (or upgrades) are issued by analysts for stocks and credit rating agencies for bonds. Downgrades are usually a response to unexpected, negative events or financial problems within a company or government. They are caused by lowered confidence in a company's prospects or by increased risk that a bond issuer won't be able to repay its debts. Downgrades lead to negative media coverage for the downgraded companies or governments and make it harder for them to borrow money. For companies issuing stock, they often cause a drop in stock prices.