What is a Downgrade?
A downgrade is an announcement of an analyst lowering their opinion on the desirability of a company as an investment. It can apply to either debt or equity.
How Does a Downgrade Work?
Downgrades can come from a variety of sources: brokerage firms, research firms, ratings agencies, etc.
Downgrades of equities can happen for several reasons, but usually they center on industry, regulatory, technology, or management changes that the analyst feels will hinder the issuer's future performance. These factors create fundamental shifts in the analyst's outlook, making the security appear either fully valued or overvalued.
Debt downgrades generally come from ratings agencies such as Moody's or Standard & Poor's (S&P). A downgrade from one of them is a major signal that an issuer is more likely to default on its debt. If a bond is downgraded to a level below investment grade (aka, 'junk'), there is often a serious sell off of those bonds, because most institutional investors are forbidden from owning junk bonds.
Why Does a Downgrade Matter?
Ratings have a large influence on the demand of a security. Downgrades (or even rumors of downgrades) tell investors that a security is now believed to be riskier, which may have a negative impact on the security's price. In turn, downgrades often lead to less trading activity and lowered liquidity.