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A change in the rating of a bond or other security in a downward direction. For example, a bond that had previously been rated AAA may be downgraded to AA. Downgrades are considered detrimental because they mean the ratings agency believes that the issuer of the security is less likely to be able to fulfill its obligations, such as coupon payments. A downgrade increases the cost of funds for the issuer because investors expect a higher return in exchange for the increased risk on the security. See also: Upgrade.
A reduction in the quality rating of a security issue, generally a bond. A downgrading may occur for various reasons including a period of losses, or increased debt service required by restructuring a firm's capital to include more debt and less equity. For example, takeover targets that engage in stock buybacks to prop up the price of their shares are subject to debt issue downgrading by the rating agencies. Compare upgrading.
Case Study In late 2000 Moody's Investors Service, a major bond rating agency, downgraded the debt of Imax Corportion, the well-known big-screen movie company. The downgrading occurred amid bad times for the movie industry. Carmike Cinemas, a major theater company, had recently filed for bankruptcy, and Regal Cinemas, America's biggest theater chain, announced it might follow Carmike's lead. Concerned about Imax's financial viability, Moody's reduced its rating for the firm's senior notes from Ba2 to B2. It also lowered the rating for Imax's convertible subordinated notes from B1 to Caa1. The downgrading of Imax debt made it more difficult for the firm to obtain additional financing.