Moody's cut its credit rating on Toyota Motor Corp <7203.T> by one notch, predicting a long slump in profitability and potential litigation costs for a massive recall that has tarnished the Japanese automaker's brand.

A ratings downgrade could make it more costly for Toyota to secure funding and service its $36 billion in outstanding debt, most of which matures between 2010 and 2012, according to Thomson Reuters data.

Moody's Investors Service lowered its senior unsecured rating on the world's largest automaker to Aa2, its third-highest ranking, from Aa1. It said the outlook was negative, leaving open the possibility of a further downgrade in the future.

Toyota faces considerable challenges to boosting profitability, including sluggish market conditions, overcapacity and the need to offer unusually large incentives to support sales, Moody's said in a release.

Toyota has recalled more than 8 million vehicles -- most of them in the United States -- and has been penalized by U.S. safety regulators for not acting quickly enough once it identified a defect with its accelerator pedals. Earlier this week, it agreed to pay a record $16.4 million federal fine for that delay.

Toyota last month began offering unprecedented and profit-sapping incentives in an effort to win back U.S. customers. Analysts expect it to post an operating loss when it reports its fiscal fourth quarter on May 11.

DOWNGRADE PRICED IN

Automakers had their ratings cut last year due to slumping industry-wide demand, but the latest Moody's downgrade is the first by a major ratings agency to hit Toyota since its recall crisis erupted in late January.

Moody's also cited the risk that product quality problems have eroded significantly and permanently its historical advantages in pricing power in predicting that profits would not return to a level commensurate with its credit rating until at least 2012.

Additionally, Toyota could face significant costs to settle lawsuits from the recall, Moody's said.

Shares of Toyota closed down 1.4 percent at 3,600 yen, in line with rivals Honda Motor <7267.T> and Nissan <7201.T>. While up 13 percent since marking a low for the year on February 4, Toyota's stock has not yet recovered to pre-crisis levels.

The downgrade is reflecting the concerns market players felt back in January in a delayed manner. I don't expect this to have a significant impact on Toyota shares, said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management.

Five-year credit default swaps on debt of Toyota were quoted at about 65 basis points, a derivatives trader said, slightly up from about 61 on Wednesday but far narrower than a peak of 290 in March last year.

Credit default swaps are used by investors as a hedge against the risk of a company failing. Spreads on Toyota, which has a healthy balance sheet and ample cash, are relatively small and roughly on par with those on Japan's sovereign debt.

NEGATIVE OUTLOOK

Moody's had knocked Toyota from its top ranking early last year and put it up for further review. Toyota was still just one of seven Japanese companies to carry the second-highest rating of Aa1 before Thursday's downgrade.

Standard & Poor's put Toyota's AA long-term ratings, its third-highest ranking, on watch negative in February for possible downgrade due to the recall. Fitch has placed its ratings on watch as well.

A Toyota spokesman said that the company was placing its greatest focus on regaining the trust of consumers and that it would work toward having its ratings upgraded in the future.

Toyota has estimated costs and lost sales from the recall would total $2 billion for the past financial year ended in March. But it has not given any estimate of the likely costs to deal with lawsuits brought by drivers.

In coming years, further impacting profitability, on an extraordinary basis, will be the litigation costs associated with the recall; and while the size of such costs is hard to quantify, they could be material, Moody's said.

Moody's said its rating would be lower if not for the support it could expect to receive from banks and other sources given its status in Japan, where it ranks as one of the largest companies and is a key driver of the economy.

Moody's said that its current rating should also find support from its very strong balance sheet and large liquid reserves, including about 2.5 trillion yen in cash and 3.6 trillion yen in investment securities at the end of last year. (Additional reporting by Edwina Gibbs, Hugh Lawson and Charlotte Cooper; Editing by Ian Geoghegan and Lincoln Feast)

Japan Toyota Recall