Are CLO Collateral and Tranche Ratings Disconnected?
62 Pages Posted: 12 Oct 2020 Last revised: 4 Nov 2020
Date Written: November 2020
Between March and August 2020, S&P and Moody's downgraded approximately 25% of collateral feeding into CLOs and only 2% of tranche values, with rating actions concentrating in junior tranches. This paper examines explanations for this potential rating disconnect. We find no evidence that: rating agency model-implied risk disproportionately affect junior tranches, collateral downgrades were too severe, CLOs accumulated pre-COVID protective cushions, or value-creation through active management. Instead, we find evidence consistent with both non-model considerations by rating agencies and strategic CLO manager trading. The end result is that CLOs are considerably riskier than their current ratings suggest.
Keywords: structured finance products, credit rating agencies, COVID-19, conflicts of interest
JEL Classification: G14, G24, G28, G32
Suggested Citation: Suggested Citation