When one of the three major credit-rating agencies places a company on negative watch, it indicates that the agency has noted a circumstance or circumstances that might cause it to downgrade the company's credit rating in the near future.

It is not a sure thing. Once a rating agency places a company on negative watch, there is a 50% chance that the company’s rating will be lowered sometime in the next three months.

Understanding Negative Watch

In addition to its credit rating, the agencies attach an outlook to a company, reflecting the agency's conclusion about the ability of that company to repay its debt. The outlook may be stable, under review, negative watch, or negative. No company or nation ever wants to be anything other than stable.

Key Takeaways

  • A company's rating is an indication of its ability to repay its debt.
  • A negative watch indicates that its ability to repay may be deteriorating.
  • A company's outlook may be stable, under review, negative watch, or negative.

Having its credit rating downgraded, or being under a negative watch, is a big blow for a company. It means it will have to pay a higher rate of interest to borrow money from a bank or issue bonds on the market for the foreseeable future.

Moreover, it is a signal that the company is likely to underperform compared to its peers. Stock investors will read it as a harbinger of bad news about a company.

It doesn't improve the company's reputation with the general public either.

The Rating Agencies' Role

The three credit ratings are Standard & Poor's (S&P), Moody's Investors Service, and Fitch Ratings. Their role is to evaluate the creditworthiness of companies, and the ratings they assign directly determine the interest rates a company must pay its bondholders.

A negative watch is the result of an analysis of a company's current financial condition.

When a rating agency downgrades a company's credit rating, it is a signal that the company will likely underperform compared to its peers.

A downgraded credit rating signifies that a company is not currently solvent enough to readily repay its debts. It may not have enough free cash flow to meet its long-term obligations, or there might be a larger issue at stake with regards to its ability to acquire new customers or retain old customers.

Ratings agencies may downgrade entire nations, or place them on negative watch.

Negative Watch and the Default Premium

Companies and countries placed on negative watch could eventually pay a default premium to access capital for growth. A default premium is an additional amount a borrower must pay in interest to compensate a lender for assuming the greater default risk.

Investors often measure the default premium as the yield on a bond issue over and above a government bond yield of similar coupon and maturity. For example, if a company issues a 10-year bond, an investor can compare this to a U.S. Treasury bond of a 10-year maturity.

Even after a 2011 downgrade due to the financial crisis, S&P rates U.S. bonds at AA+. That's it's second-highest rating. Because of the high degree of safety of U.S. debt and its stable outlook, the Treasury is able to offer bonds at a relatively modest rate of interest. The rates for all corporate bonds have to be set higher in order to attract investors.

The ratings that are placed on bonds at the time they are issued determine how much higher that premium will be. The outlook indicates to potential buyers whether its rating is likely to remain at its present level for the foreseeable future.