Are CLO Collateral and Tranche Ratings Disconnected

Between March and August 2020, S&P and Moody's downgraded approximately 25% of the collateral feeding into CLOs. We calculate the value of CLO tranche downgrades to be 2%, modestly increasing to 5.5% when considering negative watches. This paper examines possible explanations for this disconnect in rating actions. We find no evidence that: rating agency model-implied risk disproportionately affect junior tranches, collateral downgrades were too severe as compared to market prices, that CLOs accumulated protective cushions prior to the COVID crisis, or that managers are creating value by purchasing undervalued assets. We find support for both: 1) non-model considerations by rating agencies, as reported values indicate 8% of AAA tranches do not currently meet S&P's modeling criteria, and 2) portfolio managers are trading in a manner to make CLOs appear safer by rating agency criteria. Overall, our findings have current relevance for policymakers as CLOs appear considerably riskier than current ratings suggest.