Are CLO Collateral and Tranche Ratings Disconnected?

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.