Downgrade: What it is, How it Works, Warning Signs

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, including rating stocks with a buy, hold, or sell rating, to their clients. 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 assign letter grades to debt based on an evaluation of the company's ability to make good on its 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.

The reasons for a downgrade or an upgrade might be a major announcement by the company, an unexpected number in its financial statements, or a news event that has repercussions for the company or its industry.

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 S&P Global, Moody's Investors Service, and Fitch Ratings.

Bond buyers pay close attention to their ratings, and many bond funds invest only in investment-grade bonds. Debts rated "BBB" and above are considered investment grade.

It can have severe effects on the price and prospects of a company or government if the bonds it has issued are downgraded from "BBB," which is investment grade, to "BB," which is below investment grade. 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 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. Just as an individual might be able to borrow at a lower interest rate after a credit score increase, businesses can borrow money more often and more cheaply after a positive upgrade. Downgrades have the opposite effect.

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.