When building a bond allocation, most investors first turn to so-called core bonds. These are IOUs issued by Uncle Sam, corporations, and various government-sponsored entities like Fannie Mae and Freddie Mac. With investment-grade ratings, decent yields, and overall low volatility, it’s easy to see why most investors simply stop here when looking at fixed income. But there are other fixed income asset classes that can provide investors with a serious edge.
Case in point: collateralized loan obligations (CLOs).
Once reserved for institutions and high-net-worth investors, CLOs have come to the masses. And it turns out these bonds can do a lot for a core allocation, boosting returns and yields, all while helping keep volatility and drawdowns low. For investors, it’s time to consider CLOs as a core allocation tool.
A Quick Look at the Asset Class
For many pension funds, endowments, institutions, and high-net-worth investors, collateralized loan obligations (CLOs) have long been used to boost performance and add yield to a fixed income portfolio. But it’s only been recently these assets have been explored by regular joes. Advances in ETFs and the rise of private credit have expanded their adoption.
CLOs in a nutshell are basically pools of loans—typically 150 to 250—that are placed into a single security. In this case, most CLOs are senior secured loans made to corporate or private equity borrowers. But other debt, including fixed rate securities, can be part of the package. All in all, CLOs are a way for banks/lenders to remove their loans from their balances and into investors’ hands.
These packages of loans are organized in what are called ‘tranches.’ Each tranche comes with a different type of credit risk, rated AAA down to BB, with an equity tranche at the very bottom. The cash flows from the underlying loans are distributed to the CLO investors according to a waterfall method. That means the senior tranches (AAA, AA) get paid first, then so forth down the ladder. As the various underlying loans are paid off, the CLO manager will distribute those funds in order of seniority of the tranches, with any remaining proceeds returning to the equity holders at the bottom.
Benefits to a Core Bond Allocation
Top ranked tranches of CLOs have long been coveted by investors as they offer a unique set of benefits. For starters, they offer very high yields for the credit quality.
Typically, the higher tranches of a CLO pay around 5% to 6%. That’s about 1 full percentage point more than many investment-grade corporate bonds and about 2 percentage points better than U.S. Treasuries for the same duration/maturity. As we said, those bonds come with high investment-grade credit ratings.
Those high credit ratings come from the fact CLOs are often made of senior loans. In the event of bankruptcy, senior loans are prioritized to be repaid first and are often tied to a piece of equipment or asset. Recovery rates are very good for the asset class.
That led to safety among collateralized loan issues. According to alternatives manager KKR, between 1993 and 2022, the over 7,000 AAA-rated CLO tranches issued have had zero defaults. Even the lowest rated debt tranche (Ba) had only a 1.8% default rate. 1
Then CLOs come with less duration and interest rate risk than traditional investment-grade bonds as well. As we said, the vast bulk of assets in CLOs are senior loans. Senior loans are made of debt that is floating rate. Because their coupons and interest payments are tied to the Secured Overnight Financing Rate (SOFR) or previously LIBOR, they offer interest rate protection. As rates rise, so do their coupons. This provides inflation protection, but also allows them to have less interest rate sensitivity than fixed rate debt.
With these factors in tow, investors get high yields as well as safety among the asset class. It turns out these benefits make them a great core bond component.
According to fixed income manager PineBridge, a dedicated 10% to 30% allocation to CLO tranches can actually fortify their core bond portfolios. This allocation results in better risk-adjusted returns, enhanced Sharpe ratios, and lower drawdowns than portfolios constructed of only traditional fixed income investments in the Bloomberg Aggregate Bond Index. This chart from the investment manager shows the better reward/risk ratio. 2
Source: PineBridge
All in all, investors have been able to grab nearly an annual 1% return over the last decade by having CLOs in addition to the Agg.
PineBridge also notes the effect works by moving down the credit quality ladder. Adding a weighting of lower ranked CLO tranches to junk/high-yield bonds also produces better returns, lower drawdowns, and Sharpe ratios. Likewise, with going global and international investment-grade or high-yield bonds and European CLOs. Here again, investors have been able to grab meaningful extra returns by adding the asset class.
Ultimately, an allocation to collateralized loan obligations in a variety of different core fixed income portfolios adds true benefits.
Putting CLOs Into Your Core
With collateralized loan obligations adding real meaningful benefits to a core fixed income portfolio, it makes sense for investors to consider them part of their core. Adding a touch of CLOs to the Agg or other major index makes a ton of sense.
The best part is the asset class is no longer just the playground of endowments, insurance funds, and pensions. Thanks to the active ETF boom and advances in fund vehicles, adding a dose of CLOs is as easy as making a few mouse clicks in a brokerage account.
PineBridge notes there is only a 23% portfolio overlap among managers in the U.S. CLO market. That means by investing in a diversified portfolio of CLOs via an ETF, investors may actually be getting more diversification than they think. This makes ETFs a great vehicle for addition the asset class.
CLO ETFs
These ETFs were selected based on their ability to provide exposure to the CLO market. They are sorted by their one-year total return, which ranges from 6.9% to 10.2%. They have expense ratios between 0.19% and 0.50% and assets under management of $240M to $16B. They are currently yielding between 5.2% and 8.1%.
| Ticker | Name | AUM | 1-year Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| JBBB | Janus Henderson B-BBB CLO ETF | $1.35B | 10.2% | 8.1% | 0.50% | ETF | Yes |
| CLOI | VanEck CLO ETF | $749M | 8.1% | 6.3% | 0.40% | ETF | Yes |
| JAAA | Janus Henderson AAA CLO ETF | $15.6B | 7.3% | 6% | 0.22% | ETF | Yes |
| PAAA | PGIM AAA CLO ETF | $1.39B | 7.3% | 5.2% | 0.19% | ETF | Yes |
| CLOA | iShares AAA CLO Active ETF | $244M | 6.9% | 5.7% | 0.20% | ETF | Yes |
Overall, CLOs were once a quirky, institutional-only asset class. But thanks to new fund launches and continued growth, regular joes now can get in on the act. The best part is that their high credit quality, higher yields, and overall low default rates make them great compliments to a core bond portfolio. Adding them provides plenty of ebenfist and we consider them a part of our core fixed income assets.
The Bottom Line
Collateralized loan obligations (CLOs) are core bonds. No longer just for pensions, endowments, and high-net-worth portfolios, the asset class should be included in everyone’s fixed income portfolio as part of their core. Offering a yield boost and great credit quality, the asset class has a lot to offer.
1 KKR (March 2025). CLO Liabilities: Carry, Diversification and Mitigating Default Risk for Credit Portfolios
2 PineBridge (May 2025). Strengthen Your Core With a CLO Tranche Allocation
