A downgrade is a negative change in the rating of a security. This situation occurs when analysts feel that the future prospects for the security have weakened from the original recommendation, usually due to a material and fundamental change in the company's operations, future outlook, or industry. Multiple organizations provide sell-side research and rate securities with a buy, hold, or sell rating. A downgrade of stock would be moving the rating from a buy to a hold, or a hold to a sell. Debt has its rating system as well. The ratings agencies assign letter grades to debt, similar to letter grades earned in school. When a bond is downgraded, it might move from an "A" rating to a "BBB" rating.

Breaking Down Downgrade

Analysts place recommendations on securities to give their clients or investors a general idea of the expected performance of that security looking forward. These recommendations are adjusted when the basis behind the recommendation changes, such as the price of the stock or newly released data in the company's financial statements.

There are ratings agencies whose sole responsibility is to research debt issuers and assign ratings to the issuers' various types of debt. Two of the main ratings agencies are S&P and Moody's. Sometimes bond portfolios are constrained as to the type of debt they can hold based upon the rating of the debt. Debt rated "BBB" and above is considered investment grade. It can have severe effects on the price and prospects of a particular bond if it is downgraded from "BBB," which is investment grade, to "BB," which is below investment grade. Any portfolio that is mandated only to hold investment-grade debt or above will no longer be able to hold that bond and the resulting selling may drive down the price of that bond. Bonds may be downgraded because of deteriorating fundamentals of the issuing company.

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 investigation into the company's operations. Stock may also be downgraded because of deteriorating fundamentals of the issuing company, or because the current marketplace or macro environment don't favor that company's line of business.