How BBB CLOs deliver reliable returns and compelling yields

Investors looking for income in the current market environment are studying BBB-rated mezzanine tranches of collateralized loan obligations, which offer higher yields and are supported by pools of senior secured loans.

During a recent webcast, John Kim, CEO of Reckoner Capital Management, argued that CLO bonds “have traded wide to corporate yields” because of their complexity. He added that CLOs have a stronger performance history than corporates overall and that BBB and BB mezzanine tranches can show impairment rates similar to senior tranches while offering higher yields.

BBB CLO tranches differ from standard investment-grade corporate bonds in structure and collateral. Instead of an unsecured claim on a single issuer, these tranches are backed by a diversified portfolio of senior secured corporate loans that carry first-priority claims on borrower assets. When the underlying loan pool comes under stress, rule-based coverage tests can redirect cash flows from equity holders to support or pay down senior notes, which provides an additional layer of payment support for higher-rated mezzanine tranches.

Those structural features and the market’s relative unfamiliarity with CLO legal terms have kept some investors on the sidelines, and as a result CLO tranches often trade at spreads wider than comparable corporate bonds. Some managers use active selection to target tranches they view as offering higher yield per unit of risk, choosing based on loan collateral profiles, the CLO manager’s track record, and the specific structural protections in each deal.

Investors can gain exposure through actively managed funds, including exchange-traded funds that focus on BBB and BB CLO tranches. An active fund structure allows portfolio managers to buy and sell individual CLO tranches rather than taking a broad-market approach.

Market participants note principal risks, including credit risk tied to below-investment-grade corporate loans, interest-rate sensitivity, liquidity constraints, prepayment behavior that affects cash flows, leverage within CLO structures and the risk of defaults among assets in the pool. ETFs that hold CLO tranches may trade at prices that differ from net asset value; brokerage commissions and fund-specific risks can affect returns.

Prospective investors are advised to read a fund’s prospectus for detailed disclosures on investment strategy and principal risks. Fund documents also note that past performance does not guarantee future results and outline specific risks associated with CLO investments.