INSIGHTS

On November 17, 2025

AAM Viewpoints - The Resilient Carry: Why Investors Should Look at BBB CLOs with Fed Rate Cuts Expected

As the Federal Reserve (The Fed) pivots from a hiking cycle to a period of gradually reducing interest rates, fixed-income investors face the daunting task of maintaining current portfolio income without taking unnecessary risks. In this environment, Investment Grade Collateralized Loan Obligations (CLOs), specifically BBB tranches, may offer a compelling and structurally resilient investment opportunity. This is primarily due to the floating-rate nature of the asset, high credit spreads (or “carry”), and the defensive mechanism of subordination. Let’s look at these areas more closely.

Low Duration & Price Stability

One of the major appeals of CLOs, especially when rates are declining, is their floating-rate structure. CLOs are securitized pools of loans, where the underlying loans pay interest that adjusts periodically based on a floating benchmark, typically SOFR, plus a fixed credit spread.

This floating rate feature means CLOs generally have very low-interest rate duration, measured in months rather than years. When the Fed cuts the policy rate, fixed-rate bonds generally see their prices rise, but they also expose investors to the risk of falling bond prices if rates were to later reverse course. Conversely, CLO prices are insulated from negative price volatility associated with declining rates because their coupons simply adjust downward, maintaining price stability and preventing the principal depreciation which can be common in fixed-rate assets. This low duration profile can be beneficial in helping investors protect capital while rates fall.

Superior Credit Spread and High Carry Potential

As the benchmark rate (SOFR) declines, the credit spread offered by BBB-rated CLOs becomes a significantly more dominant component of the all-in yield. BBB-rated CLOs are classified as mezzanine debt, positioned just above the lowest-rated and high-risk equity tranches. Due to their complexity and lower liquidity compared to corporate bonds, CLOs currently offer a higher spread premium than similarly rated corporate debt. This structural premium, or “high carry”, could be an income cushion and can have the potential to help investors maintain healthy levels of income when rates are declining.

As the chart below depicts, assuming a hypothetical 50 basis points (0.01% of 1%) rate decline, BBB CLOs could potentially experience less of a hit as a percentage of total yield verse their higher rated counterparts. For this reason, BBB CLOs may potentially be the natural “Next Step” for AAA-only CLO investors looking to maintain attractive levels of income as further rate cuts are likely expected.

Historically, this superior carry has allowed CLOs to outperform similarly rated fixed-rate assets through varying rate environments. As the floating benchmark rate drops, the high credit spread of the BBB tranche could potentially help a security to continue generating an attractive absolute yield, thus offering support for investors to solve the problem of diminishing income across the broader credit market.

Structural Resilience and Credit Improvement

Finally, CLOs are structured in a way that lower-rated tranches provide substantial protection for higher-rated tranches via subordination – this is a key structural feature of CLOs. For BBB CLOs, the equity and BB-rated tranches absorb the first losses from any defaults in the underlying loan pool. For a BBB tranche to incur principal losses, defaults in the loan pool would have to be catastrophic, far exceeding historical worst-case scenarios. In fact, according to S&P rating, the CLO 2.0 generation of transactions which began in 2010 in the aftermath of the Global Financial Crisis, not a single BBB CLO has defaulted as of September 30^th, 2025 (Source: S&P Global Ratings). This structural integrity can potentially help investments withstand significant economic stress.

Furthermore, when thinking about a falling-rate environment, this directly benefits the underlying leveraged corporate borrowers by reducing their interest expense. Lower debt servicing costs improve the company’s cash flow and credit metrics, which can lead to fewer defaults within the CLOs loan pool. This improving fundamental credit quality can act as an additional tailwind, supporting the value and stability of the BBB tranche, just as it is needed most.

Conclusion

In conclusion, BBB CLOs may provide a strategic investment anchor during a rate-cutting cycle. They have the potential to deliver high resilient income due to their credit spreads while mitigating interest rate risk through their floating rate nature. We believe this balance of attractive “carry” and protection makes them an appealing option for investors seeking yield and risk adjusted returns in the face of potential fed cuts.

Collateralized Loan Obligations (CLOs) are complex investments backed by pools of corporate loans, and BBB-rated tranches, while investment grade, still carry risks of default and loss. These securities may be less liquid and more sensitive to market volatility and interest rate changes, and their performance depends on the manager’s decisions. Regulatory changes and poor market conditions can further impact returns, and protections built into CLO structures may not fully prevent losses. Investors should review all offering documents and consult a financial professional, as investing in CLOs may result in loss of principal and is not suitable for everyone.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

CRN: 2025-1107-12995 R