CLO Debt Investing: AAA to BBB Tranches

CLO debt tranches—from AAA to BBB and below—offer institutional investors floating-rate credit exposure with structural protections unavailable in traditional corporate bonds. With yields ranging from SOFR + 120 bps (AAA) to SOFR + 600+ bps (BB), CLO debt serves diverse investment mandates across the risk spectrum.

This guide covers the strategies, risks, and best practices for investing in CLO debt tranches, from ultra-conservative AAA allocations to yield-focused mezzanine positions.

Overview: CLO Debt Tranche Profiles

Note: Spreads as of Q4 2024. Actual spreads vary by manager tier, market conditions, and deal structure.

AAA Tranches: The Conservative Core

Investment Profile

• Rating: AAA by Moody's, S&P, and/or Fitch
• Yield: SOFR + 120-150 bps (absolute: 6.2-6.5% when SOFR = 5.0%)
• Default history: Zero AAA CLO defaults since 1994
• Subordination: 35-40% of capital structure absorbs losses before AAA is impaired
• Typical minimum: $250K-$1M per tranche

Why Institutions Buy AAA CLOs

1. Yield Premium Over AAA Corporates

• AAA CLO tranches yield 40-80 bps more than AAA-rated corporate bonds of similar duration
• Example (Q4 2024): AAA CLO at 6.3% vs. AAA corporate bond at 5.7% = 60 bps pickup

2. Floating-Rate Exposure

• CLO coupons reset quarterly based on SOFR
• Natural hedge against inflation and rising rates
• Low duration risk (typically 0.25-0.5 years modified duration)

3. Structural Protection

• 35-40% subordination cushion
• Coverage tests divert cash flows to AAA if portfolio deteriorates
• Diversification across 150-300 loans in underlying portfolio

4. Regulatory Treatment

• AAA CLOs qualify as High-Quality Liquid Assets (HQLA) for banks (Level 2B)
• Favorable capital treatment for insurance companies under RBC/Solvency II

AAA Risk Considerations

While AAA CLOs have never defaulted, investors face:

• Mark-to-market volatility: Secondary market prices can decline 5-15% during stress (March 2020: AAA CLOs fell to 85-92 before recovering)
• Spread widening risk: AAA spreads can widen 50-150 bps during dislocations
• Refinancing risk: Equity may refinance AAA at lower spreads, forcing reinvestment at worse terms
• Extension risk: If portfolio deteriorates, early amortization may be delayed

AAA Strategy: Tier 1 Managers vs. Tier 2/3

Investor choice: Conservative buyers prefer Tier 1 managers (Ares, Blackstone, Oak Hill) for liquidity and reputation. Yield-focused buyers may target Tier 2/3 for spread pickup, accepting lower liquidity.

AA and A Tranches: The Mezzanine Sweet Spot

AA Tranches

• Yield: SOFR + 165-200 bps
• Subordination: 25-32% (slightly less cushion than AAA)
• Default history: Near-zero defaults; extremely rare downgrades
• Investor appeal: Higher yield than AAA with minimal additional risk

A Tranches

• Yield: SOFR + 200-240 bps
• Subordination: 18-25%
• Historical performance: Very low default rates; occasional downgrades during severe stress
• Investor appeal: Investment-grade rating with high-yield-like returns

Why AA/A Tranches Are Popular

Risk-Adjusted Returns: AA/A tranches historically offer the best risk-adjusted returns in the CLO capital structure:

• Yields 40-100 bps higher than AAA
• Still maintain substantial subordination (20-30%)
• Investment-grade ratings (satisfy regulatory requirements)
• Very low default risk (coverage tests protect these tranches almost as well as AAA)

Institutional Fit:

• Insurance companies seeking yield without exiting investment-grade mandates
• Pension funds targeting 6-7% returns with moderate risk
• Asset managers building diversified credit portfolios

BBB Tranches: The Crossover Zone

Investment Profile

• Yield: SOFR + 285-350 bps (absolute: 7.9-8.5% when SOFR = 5.0%)
• Subordination: 11-18%
• Rating: BBB (lowest investment-grade tier)
• Risk: Moderate; payment deferrals possible during severe stress

BBB Investor Considerations

Advantages:

• Still investment-grade rated (satisfies many mandates)
• Yields approach high-yield bond territory (7-9%)
• 11-18% subordination provides meaningful cushion
• Floating-rate exposure (hedges inflation/rate risk)

Risks:

• Coverage test sensitivity: BBB tranches are often the first to experience interest payment deferrals if OC/IC tests fail
• 2008-2009 precedent: Some BBB tranches had interest payments diverted to senior tranches for 12-24 months
• Refinancing risk: Equity may call deal early, forcing reinvestment at lower yields
• Downgrade risk: BBB tranches are more likely to be downgraded to BB during stress (losing investment-grade status)

BBB Strategy: New Issue vs. Secondary

BB and B Tranches: High-Yield Territory

Investment Profile

• Yield: SOFR + 500-700+ bps
• Rating: BB / B (non-investment grade)
• Subordination: 6-12% (only equity below)
• Risk: High; vulnerable to coverage test failures and payment deferrals

Who Buys BB/B CLO Debt?

• High-yield bond funds (treating CLO BB/B as HY bond alternatives)
• Hedge funds seeking leveraged credit exposure
• Credit opportunity funds buying distressed tranches at discounts

Why BB/B Over Equity?

BB/B tranches offer a middle ground between equity and investment-grade debt:

• Fixed coupon: Unlike equity (residual), BB/B have contractual coupons (though deferrable if tests fail)
• Priority over equity: BB/B are paid before equity in the waterfall
• Lower risk than equity: 6-12% subordination cushion protects against some losses
• Yield approaching equity: 9-12% all-in yields approach equity returns with less volatility

BB/B Risk: Payment Deferrals

Scenario: Portfolio deteriorates → OC/IC tests fail → Cash diverted from BB/B to AAA/AA.

• 2008-2009 experience: Many BB tranches had interest payments deferred for 12-36 months
• Eventual recovery: Most BB tranches that deferred payments eventually paid accrued interest once tests cured
• Principal risk: If losses exceed subordination, BB/B can experience principal impairment

Primary Market vs. Secondary Market Strategies

Primary Market (New Issue) Strategy

Process:

1. Participate in roadshow; review preliminary portfolio
2. Submit orders during book-building (indicate tranche and size)
3. Receive allocation based on demand and investor relationships
4. Fund at closing (typically 100 cents on the dollar)

Advantages:

• Access to Tier 1 managers before paper trades in secondary
• Full due diligence access (manager meetings, detailed portfolio review)
• Structural protections negotiated upfront
• No liquidity discount

Disadvantages:

• Must commit before portfolio is finalized (warehouse risk)
• New issue spreads may tighten in secondary if market improves
• Competing with other institutional investors for allocations

Secondary Market Strategy

Opportunities:

• Distressed buying: Purchase BBB/BB tranches at 70-85 cents when coverage tests fail but recovery is expected
• Upgrade plays: Buy A-rated tranches at 98-99 if manager is likely to cure tests and refi
• Yield maximization: Buy Tier 2/3 manager AAA at wider spreads than Tier 1

Risks:

• Information asymmetry: Seller may know something you don't
• Liquidity: Hard to exit if wrong—secondary market can freeze during stress
• Structural traps: May inherit deals with poor covenants or weak managers

Portfolio Construction: Diversification Strategies

Strategy 1: All-AAA Core

• Allocation: 100% AAA tranches
• Diversification: 15-30 different CLOs
• Manager mix: 70% Tier 1, 30% Tier 2 (for yield pickup)
• Expected return: SOFR + 125-140 bps
• Use case: Conservative institutions; pension funds; insurance general accounts

Strategy 2: Mezzanine Ladder

• Allocation: 50% AAA, 30% AA, 20% A
• Expected return: SOFR + 150-170 bps
• Use case: Moderate risk-takers seeking yield without exiting investment grade

Strategy 3: Crossover Portfolio

• Allocation: 40% A, 40% BBB, 20% BB
• Expected return: SOFR + 280-350 bps
• Use case: Credit-focused funds; high-yield allocators seeking structural protections

Due Diligence Checklist for CLO Debt Investors

Manager Evaluation

• Historical default rates vs. market (lower = better)
• Coverage test failure frequency (fewer failures = stronger manager)
• Tier classification (Tier 1 preferred for liquidity)
• AUM and vintage diversity (larger, more experienced = better)

Portfolio Quality Metrics

• Weighted Average Rating Factor (WARF): Lower = higher quality. Target: 2700-3000.
• CCC exposure: Should be < 7.5%. Lower = safer.
• Weighted Average Spread (WAS): Higher spread portfolios generate more cushion. Target: 425-475 bps.
• Diversity Score: Higher = more diversification. Target: 70+.

Structural Protections

• OC/IC cushions: How far above trigger levels? More cushion = safer.
• CCC haircuts: How are CCC loans valued in tests? Conservative = 70-85 cents.
• Call protection: Non-call period (typically 2 years) protects against early refinancing.
• Reinvestment period: Longer = more manager trading flexibility.

Tax Considerations

• Interest income: CLO debt payments are ordinary income (not qualified dividends)
• Tax-deferred accounts: Best held in IRAs, 401(k)s, or pension accounts to avoid annual income tax
• UBTI: Generally not an issue for debt (unlike equity)
• Non-U.S. investors: May face withholding taxes unless treaty provisions apply

Key Takeaways by Tranche

Further Reading

• CLO Structure – Understand tranching and subordination
• Coverage Tests – How OC/IC tests protect debt investors
• Manager Rankings – Evaluating manager quality
• Historical Returns – Performance by tranche and vintage
• CLO ETFs – Retail access alternative