CLO Tranches Explained: AAA to Equity
CLO tranches are layers of securities with different risk-return profiles, created through subordination. Senior tranches (AAA) receive first claim on cash flows and have lowest risk. Junior tranches (equity) receive residual cash flows and bear first losses. This guide explains each tranche's characteristics, typical investors, and investment considerations.
The Capital Stack
| Tranche | % of Capital | Rating | Yield (SOFR+) | Risk Level | Typical Investors |
|---|---|---|---|---|---|
| AAA | 60-65% | AAA | 120-150 bps | Very Low | Insurance, pensions, banks |
| AA | 7-9% | AA | 165-200 bps | Low | Insurance, asset managers |
| A | 5-7% | A | 200-240 bps | Low-Moderate | Asset managers, funds |
| BBB | 5-7% | BBB | 285-350 bps | Moderate | Credit funds, crossover buyers |
| BB | 4-6% | BB | 500-600 bps | Moderate-High | HY funds, hedge funds |
| Equity | 8-12% | Unrated | 12-18% IRR | High | Hedge funds, PE, family offices |
AAA Tranches: Maximum Safety
Risk Profile: Lowest in CLO capital structure. Protected by 35-40% subordination cushion. Zero defaults in 30+ years.
Return Profile: SOFR + 120-150 bps (6-6.5% all-in when SOFR = 5%). Modest yield premium over AAA corporates with floating-rate benefit.
Key Features:
- First claim on interest and principal
- Coverage tests divert cash from junior tranches if portfolio deteriorates
- Lowest duration risk (floating-rate, short effective maturity)
- Highest liquidity in secondary markets
Risks: Mark-to-market volatility (8-15% price declines during stress), refinancing risk, reinvestment risk.
Learn more about investing in AAA CLOs →
AA and A Tranches: The Sweet Spot
Investment Thesis: Best risk-adjusted returns in CLO capital structure. Substantial subordination (20-30%) with investment-grade ratings and meaningful yield pickup over AAA.
AA Features:
- SOFR + 165-200 bps yield
- 25-32% subordination protection
- Near-zero historical default rate
- Popular with insurance companies seeking yield within IG mandates
A Features:
- SOFR + 200-240 bps yield (approaching HY territory)
- 18-25% subordination protection
- Very low default rate (< 0.1% historically)
- Attractive for yield-focused IG allocators
BBB Tranches: The Crossover Zone
Characteristics: Lowest investment-grade rating but yields rivaling high-yield bonds. Moderate risk of payment deferrals during severe stress.
2008-2009 Experience: ~25% of BBB tranches experienced interest payment deferrals (cash diverted to AAA/AA). Most eventually paid accrued interest, but deferrals lasted 12-24 months.
When to Consider:
- Seeking HY-like yields with IG rating
- Can tolerate temporary payment interruptions
- Prefer structural protections over direct HY bond exposure
BB and B Tranches: High Yield with Structure
Risk-Return: Non-investment grade ratings but priority over equity. Yields of 9-12% (SOFR + 500-700 bps) with 6-12% subordination cushion.
Key Considerations:
- High likelihood of payment deferrals during recessions
- Potential for principal losses in severe scenarios (2007-2008 vintages: 10-30% losses on some BB tranches)
- Better risk-adjusted returns than direct HY bonds (structural protections matter)
Equity: First Loss, Highest Return
Structure: Receives residual cash flows after all debt is paid. Absorbs 100% of losses until wiped out.
Return Targets: 12-18% gross IRR, but highly variable:
- Best vintages (2010-2013): 15-20% IRRs
- Worst vintages (2007-2009): 3-7% IRRs or losses
Risk Factors:
- Default sensitivity: 1% increase in default rate = 200-300 bps IRR reduction
- Coverage test failures: Cash distributions cease (sometimes for years)
- Manager quality: Tier 1 managers outperform by 300-500 bps
- Illiquidity: Secondary market bid-ask spreads of 5-15 points
Tranche Comparison: Key Metrics
| Metric | AAA | BBB | BB | Equity |
|---|---|---|---|---|
| Historical Default Rate | 0.00% | 0.58% | 2.14% | N/A |
| Payment Deferral Risk (2008) | 0% | 25% | 45% | 90%+ |
| Typical Hold Period | 3-5 years | 4-7 years | 5-10 years | 10-12 years |
| Liquidity (Bid-Ask) | 10-30 bps | 50-100 bps | 100-200 bps | 300-1000 bps |
| Min Investment (Direct) | $250K-1M | $500K-1M | $1M+ | $5-25M |
Investment Strategy by Tranche
Conservative Strategy
Allocation: 100% AAA or 70% AAA / 30% AA
Target Return: 6-6.5%
Risk: Minimal credit risk; mark-to-market volatility only
Best For: Retirees, conservative institutions, bond replacements
Balanced Strategy
Allocation: 50% AAA / 30% AA / 20% A
Target Return: 6.5-7.0%
Risk: Low credit risk; moderate market volatility
Best For: Moderate risk-takers, pension funds
Yield-Focused Strategy
Allocation: 40% A / 40% BBB / 20% BB
Target Return: 8-9%
Risk: Moderate; payment deferral risk in stress
Best For: HY allocators, credit opportunity funds
Aggressive Strategy
Allocation: CLO equity (diversified across managers)
Target Return: 12-18%
Risk: High; first-loss position
Best For: Sophisticated investors, long time horizons
Further Reading
- CLO Structure – How tranching works
- Coverage Tests – Protection mechanisms
- CLO Debt Investing – Strategies by tranche
- Historical Returns – Performance by tranche