Are CLO Collateral and Tranche Ratings Disconnected?

Abstract

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. Both S&P and Moody's modeling indicate that the impacts should have been considerably larger, especially for higher-rated tranches. Neither changes in correlation nor the accumulation of pre-COVID-19 protective cushions can explain the downgrade asymmetry on upper tranches. Instead, CLO managers repositioned their collateral pools to dampen the negative credit shock and rating agencies incorporated qualitative adjustments in their CLO ratings. Important potential policy and market implications from these findings are discussed.

CLO Performance

“…Another potential source of equity abnormal returns comes from ratings inflation (Griffin and Nickerson (2020)). If CLO debt tranche ratings underestimate default risk, than debt investors may be lured into overpaying for what they incorrectly believe are safer securities.…”

“…However, in aggregate, CLO managers do not exhibit superior skill in selecting or trading collateral relative to other participants in the leveraged loan market. Griffin and Nickerson (2020) argue that CLO tranches are significantly riskier than their credit ratings suggest during the COVID‐19 crisis. We show that over the history of the CLO market, debt tranches experience significantly lower default rates than similarly rated corporate bonds.…”