Skip to main content
diversification.com
← Back to R Definitions

Rating downgrade

What Is a Rating Downgrade?

A rating downgrade is a reduction in the credit rating of a security, company, or country. This financial event falls under the broader category of credit risk management. Credit rating agencies, such as Moody's, Standard & Poor's (S&P), and Fitch Ratings, assign these ratings based on an assessment of the issuer's financial health and its ability to meet its debt obligations. A downgrade signals that the issuer's creditworthiness has deteriorated, increasing the perceived risk for investors.

When a rating downgrade occurs, it suggests that the entity is more likely to default on its debt. This can happen for various reasons, including worsening financial performance, increased debt levels, negative economic outlooks, or significant operational challenges. The implications of a rating downgrade can be substantial, affecting borrowing costs, investor confidence, and market perceptions.

History and Origin

The concept of credit ratings emerged in the early 20th century to provide investors with standardized assessments of bond issuers' ability to repay debt. John Moody, who began publishing bond ratings in 1909, is widely credited with establishing the first such service. Over time, other agencies like Standard & Poor's and Fitch Ratings also rose to prominence. These agencies play a crucial role in the global financial system by offering independent assessments of credit risk.

A significant historical event demonstrating the impact of a rating downgrade occurred in August 2011, when Standard & Poor's lowered the U.S. government's long-term credit rating from AAA to AA+. This was the first time in history that the U.S. had its top-tier rating cut, reflecting S&P's concerns about political divisions impacting the nation's ability to address its fiscal challenges.13,12 The downgrade highlighted the critical role that credit ratings play, even for sovereign entities. While the immediate market reaction varied, the event underscored the sensitivity of global financial markets to these assessments.11

Key Takeaways

  • A rating downgrade indicates a reduction in an entity's creditworthiness.
  • It implies a higher risk of default for debt instruments issued by the entity.
  • Credit rating agencies like Moody's, S&P, and Fitch issue these ratings.
  • Downgrades can lead to increased borrowing costs and decreased investor confidence.
  • They serve as a significant signal to the market regarding an issuer's financial health.

Interpreting the Rating Downgrade

Interpreting a rating downgrade involves understanding the specific rating scales used by different agencies and the reasons behind the change. Each agency employs its own alphanumeric or symbolic scale, with higher ratings (e.g., AAA, Aaa) indicating lower credit risk and lower ratings (e.g., BBB-, Baa3, C) indicating higher credit risk. A downgrade means moving down this scale, often by one or more "notches." For instance, if an entity's rating moves from A+ to A, it's a single-notch downgrade.

The context surrounding the downgrade is crucial. Analysts examine the agency's rationale, which often includes details about declining financial ratios, increasing debt-to-equity levels, or adverse industry trends. A downgrade due to a temporary operational issue might be viewed differently than one stemming from a fundamental shift in an entity's long-term economic prospects. Understanding the severity and underlying causes of a rating downgrade is essential for investors to assess the impact on the value of debt and future investment decisions.

Hypothetical Example

Consider "Alpha Corporation," a publicly traded manufacturing company. For years, Alpha Corporation has held a "BBB+" credit rating from a major agency, indicating a moderate level of credit risk. However, due to a sharp decline in sales over two consecutive quarters and a significant increase in its operating expenses, its cash flow has substantially decreased.

The credit rating agency, after reviewing Alpha Corporation's updated financial statements, decides to lower its rating to "BBB-". This rating downgrade signals to the market that Alpha Corporation's financial health has weakened and its ability to service its debt has become more precarious. Investors holding Alpha Corporation's bonds might see their value decline, and if Alpha Corporation needs to issue new debt, it will likely face higher interest rates due to the increased perceived risk.

Practical Applications

Rating downgrades have wide-ranging practical applications across financial markets:

  • Bond Markets: A primary impact of a rating downgrade is on the bond market. When a bond issuer's rating is lowered, the value of its existing bonds typically decreases, and its yield to maturity increases. This makes it more expensive for the issuer to borrow new funds. For example, in 2012, Moody's downgraded Italy's government bond rating, putting pressure on the country's borrowing costs.10
  • Investment Decisions: Investors use credit ratings as a key input for investment analysis. A downgrade may trigger institutional investors, such as pension funds and mutual funds, to sell downgraded securities if their investment mandates restrict holdings to certain credit quality levels. This can lead to significant selling pressure and further price declines.
  • Corporate Finance: For companies, a rating downgrade can increase the cost of capital, making it more challenging and expensive to finance operations, expansions, or acquisitions. It can also impact credit lines and relationships with lenders. In July 2025, Moody's Ratings downgraded Dow's senior unsecured credit rating, citing depressed earnings and governance concerns, which could impact the company's financial outlook.9
  • Sovereign Debt: Downgrades of sovereign debt, like the U.S. downgrade in 2011, can have systemic implications, affecting global benchmarks and the perceived safety of government securities.8, These events can ripple through various asset classes and influence international capital flows.

Limitations and Criticisms

Despite their widespread use, credit ratings and particularly rating downgrades face several limitations and criticisms:

  • Lagging Indicators: Credit ratings are often criticized for being lagging indicators, meaning they may only reflect problems after they have become evident in the market. By the time a rating downgrade occurs, many sophisticated investors may have already reacted to the underlying financial distress.
  • Conflicts of Interest: A significant criticism revolves around potential conflicts of interest, particularly in the "issuer-pay" model where the entity being rated pays the rating agency. This model has raised concerns about the objectivity of ratings, especially highlighted during the 2008 financial crisis, where many complex securities that contributed to the crisis had received high ratings. The Dodd-Frank Act of 2010 aimed to enhance the regulation and oversight of Nationally Recognized Statistical Rating Organizations (NRSROs) to address these issues.7,6
  • Methodology Concerns: Critics also point to the potential for primitive methodologies and a lack of transparency in how ratings are determined.5 This can make it difficult for investors to fully understand the assumptions and models used by rating agencies. The Federal Reserve has also faced criticism for relying on credit ratings in some of its lending programs despite congressional mandates to reduce such reliance.4
  • Market Impact: The powerful influence of rating agencies means that a downgrade can sometimes exacerbate market panics, leading to forced selling and increased volatility, even if the fundamental change in creditworthiness is not as severe as the market reaction suggests.3

Rating Downgrade vs. Outlook Change

A rating downgrade is often confused with an outlook change, but they represent distinct assessments of an entity's creditworthiness within corporate finance.

A rating downgrade is an actual reduction in the assigned credit rating. This signifies that the agency has formally revised its assessment of the issuer's ability to meet its financial obligations downward. It reflects a current determination that the credit risk has increased. For example, a company might move from an "A" rating to an "A-" rating.

An outlook change, on the other hand, is an indication of the potential direction of a credit rating over the medium term, typically six months to two years. It signals whether a rating is likely to be upgraded, downgraded, or remain stable. An outlook is typically "positive," "negative," or "stable." A "negative" outlook suggests a higher probability of a downgrade in the future, while a "positive" outlook suggests a potential upgrade. It does not represent an immediate change to the rating itself, but rather a forward-looking signal based on anticipated developments. For example, Moody's recently changed FNM S.p.A.'s outlook to stable from negative, while affirming its long-term issuer rating.2

The key difference lies in their immediacy and certainty: a downgrade is a definitive action, while an outlook change is a forward-looking indication of potential future action. Investors pay close attention to both, as an outlook change often precedes an eventual rating downgrade or upgrade.

FAQs

What causes a rating downgrade?

A rating downgrade can be caused by various factors, including a deterioration in financial performance, an increase in debt levels, a negative economic outlook for the company's industry or country, poor management decisions, or unforeseen events like legal challenges or natural disasters. Essentially, anything that significantly increases the perceived risk of an entity failing to meet its financial obligations can trigger a downgrade.

How do rating downgrades affect borrowing costs?

When a rating downgrade occurs, it signals to lenders and investors that the entity is riskier. To compensate for this increased risk, lenders will demand a higher risk premium, which translates into higher interest rates on new debt. This makes it more expensive for the downgraded entity to borrow money. For existing debt, while the coupon rate remains fixed, the market price of the bond will typically fall, effectively increasing its yield for new buyers.

Are all credit rating agencies regulated?

In the United States, major credit rating agencies are regulated by the Securities and Exchange Commission (SEC) and are designated as Nationally Recognized Statistical Rating Organizations (NRSROs).1,, The SEC oversees their operations to promote accuracy and reduce conflicts of interest, particularly following reforms introduced by the Dodd-Frank Act. However, not all organizations that provide credit assessments are necessarily NRSROs.

Can a rating downgrade be reversed?

Yes, a rating downgrade can be reversed if the underlying financial conditions or economic outlook that led to the downgrade improve significantly. If an entity demonstrates a sustained improvement in its financial health, reduces its debt, or addresses the issues that caused the downgrade, rating agencies may eventually upgrade its credit rating. This process is known as a rating upgrade.

What is the difference between a corporate credit rating and a sovereign credit rating?

A corporate credit rating assesses the creditworthiness of a private company, indicating its ability to meet its financial obligations. A sovereign credit rating, on the other hand, assesses the creditworthiness of a national government and its capacity to repay its public debt. While both indicate credit risk, sovereign ratings often have broader implications for a country's economy and its financial markets.