Earth to investors:

Gap

(GPS) - Get Report

isn't out of the woods yet.

For the third time in less than a year, credit rating agency Moody's downgraded Gap debt Monday. The downgrade affects about $2.1 billion of debt, and puts Gap's rating one step shy of junk status. In a statement, Moody's said Gap remains "on review for further possible downgrade."

The downgrade, which has the effect of raising the company's borrowing costs, is sobering news to investors who have recently bought the stock on the notion that the worst is behind Gap. On Jan. 10, the apparel retailer reported that same-store sales in December declined 11%, much better than the most pessimistic Wall Street estimates, sending shares up about 13%. Shares dropped 23 cents during trading Monday to close at $15.55. In after-hours trading on Island, shares were trading at $15.58.

Gap didn't immediately return a call seeking comment.

Spinning Forward

News of the downgrade, which was released after the close of trading, didn't come as a complete surprise, because Moody's had previously put Gap on notice for a possible downgrade. The rating agency had previously lowered its rating on Gap last April and again in October; rivals S&P and Fitch also have Gap ratings in the lower reaches of investment grade status.

"It's still investment grade," says Todd Slater, who covers the company for Lazard Freres, "so until, if and when, there's a downgrade to junk it's not really a big deal." More important for investors, he says, is how Gap does in the fourth quarter, results of which it is expected to report in February. (Slater recently upgraded Gap to hold from sell, and his firm doesn't have a banking relationship with the company.)

In its sales release on Jan. 10, the company said it expected a loss of no worse than 6 cents a share, much better than the then-consensus estimate of a 12-cent loss, according to Thomson Financial/First Call.

Moody's said it still sees Gap's liquidity as "acceptable," and fears that the company could violate its debt covenants have waned. In December, research outfit Grant's Investor published a report that said the company could be in danger of violating its debt agreements should its earnings before interest, taxes and depreciation, or EBITDA, a measure of cash flow, fall below $1.084 billion when its fiscal year ends in January. The company replied that Grant's "misestimated" the level of EBITDA needed to meet its agreements, a response that most on Wall Street have accepted.

Unfashionable

Gap was once one of the favorite growth companies on Wall Street. But for more than a year and a half it has

been on the outs, as same-store store sales have declined sharply amid a series of fashion faux pas. Meanwhile, the company has continued to open new stores at such a feverish pace that many analysts now say that new stores are cannibalizing older ones.

The company still has some believers on Wall Street, mainly because of its strong brand name and its chief executive, Millard Drexler.

But even those believers have Gap on a short leash. Gap bull Richard Jaffe, of UBS Warburg, has previously said that a $700 million bond offering in November "saved the day" and bought the company a year to get its act together before it could face a liquidity crisis.

That's hardly the ringing endorsement this company could use right about now.