What Is a Downgrade?
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.
A downgrade may be contrasted with an upgrade.
- A downgrade refers to a negative change in an analyst's outlook of a particular security's valuation based primarily on that security's improving fundamentals.
- A downgrade to a specific security is usually triggered by qualitative and quantitative information that contributes to a decrease in the financial valuation of that security.
- The biggest drawback of a downgrade is that it increases a company's cost of capital, for both debt and equity, and often results in an immediate hit to share price.
How Downgrades Work
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.
For equity and debt securities, a downgrade generally leads to more negative press. Behind the scenes, the biggest drawback to an upgrade is a higher cost of capital, for both debt and equity. A lower cost of capital translates into a lower discount rate, which leads to a higher valuation and firm valuation. Similar to how an individual might be able to borrow at a cheaper interest rate after a credit score "upgrade," businesses can access the capital markets more often and at cheaper rates after a positive upgrade event - and downgrades have the opposite effect.
Beyond an outright downgrade event, credit rating agencies and equity valuation shops both publish watchlist or similar lists indicating securities or companies prime for a downgrade. Investors and creditors alike keep a close eye on potential directional changes to a security or business prospect.
An example of an equity downgrade would be an analyst raising the investment rating for a particular stock (or sector) from "buy" to "hold." A downgrade of this nature would sometimes be accompanied by a downward revision in the analyst's target price for the stock. As a result, the shares that morning fall by 2.5% as investors re-evaluate the new lower price target and recommendation.