How Credit Rating Agency Downgrades Affect Share Prices

Stock market prices are very volatile and are often affected by various events that happen around the world. This is so regardless of if the event is directly impacting the company or not. The degree of change would probably be determined by how closely related the event is to the company. That is why events like a credit agency downgrade affect the share price of a company tremendously.

Credit rating agencies such as Fitch, Moody and Standard and Poor’s assign ratings for companies’ base on the credit worthiness of the company. Each of the agencies has their own rating system, but typically the ones that are high on the alphabetical list are the ones that are said to be more credible. Ratings from credit rating agencies carry a lot of weight because they are usually the benchmark used by various parties like economic analysts, investors and bankers; all of whom use ratings for the purpose of evaluating their decision to invest in the company or not. Therefore a credit rating downgrade will definitely have a negative impact on the share price of the company involved because it means that the company is not as financially sound as it was previously. For example, Moody’s recently downgraded the credit rating for 15 American banks including Citigroup and Bank of America which caused the shares of the banks involved to dive by as much as 25 percent in a single week.

The main reason why credit ratings affect stock prices is because credit rating downgrades make it more difficult and costly for the company to borrow from external sources. When a company has a good credit rating, the cost of borrowing is low because the credit worthiness of the company is high. For example, when a company like Microsoft, which has a AAA rating ( Standard and Poor’s) goes out to borrow external debt, the cost of borrowing is lower than what a company like Nokia, with a BBB rating would need to pay. When the cost of doing business is higher, the profit of the company will be affected; hence the lack of confidence shown in the share price.

As mentioned, the decision of the credit rating agencies often have a major impact on share prices and the market as a whole. The agencies however, are not infallible to making mistakes and have been lambasted in the past for being too powerful in deciding which company gets the upgrade or downgrade. CEO’s of companies are often heard complaining about an “accountability gap” in the credit rating industry as the agencies are not accountable to any government or industry organizations. However, until such a time where an alternative method of evaluating the credit worthiness of a business or company is found and agreed upon, any decision by the credit rating agencies will continue to have a major impact on share prices.