The role of CLOs in a diversified portfolio

Judging by conversations with investors, collateralised loan obligations (CLOs) have become popular. This paper focuses on the debt tranches of CLOs and asks whether they can play a role in asset allocation processes. Our conclusion is that the various CLO tranches provide a flexible suite of risk/reward possibilities and that they can play an important role in optimal portfolios (based on an analysis of historical returns in the US and Europe).

Main conclusions

• The global market capitalisation of the CLO asset class now exceeds $1.2 trillion¹, with around two-thirds of that in AAA tranches.
• There have been surprisingly few defaults in the data available since 1993, with none in the AAA and AA-rated categories (based on Moody's Ratings data).
• Historical returns suggest that CLO debt tranches offer a range of risk-reward possibilities (see Figure 1), with lower quality tranches offering higher returns but with higher volatility.
• Given the return proximity of the various tranches to other asset categories (AAA is similar to cash, B is similar to stocks, for example), it would be unsurprising if they could play a role in asset allocation processes.
• Optimisation results, based on historical returns, suggest that CLOs feature in optimal allocations all along the efficient frontier (for example, AAA-rated CLOs dominate allocations at the low volatility end of the efficient frontier, while B-rated CLOs dominate the high volatility end - only AAA, BBB and B tranches were considered in the optimisation exercise).
• That analysis was based on US data from 2012 to 2025 (the longest data history available), which may penalise longer duration fixed income assets, given the rise in interest rates and yields over that period. An alternative analysis based on a period that does not have such a trend in rates gives broadly similar results.
• There may be some evidence of cyclicality in the relative performance of CLOs but there is no consistent link with central bank rate cycles. CLO yield spreads are currently mixed versus historical norms. We think they are reasonable.

Introduction to CLOs

Investor discussions suggest Collateralised Loan Obligations (CLOs) have become popular. This paper explores the potential role of CLO debt tranches within a multi-asset framework, based on available data from US and European markets.

What is a CLO?

A CLO is a limited life financial structure that usually pools together broadly syndicated loans (assets) - typically senior secured loans from diverse corporate borrowers (see glossary of terms) - and finances the purchase by issuing multiple tranches of debt (liabilities), plus an equity tranche. These tranches are organised in a “waterfall” structure, meaning that the most senior debt (AAA-rated) receives principal and interest payments first, while junior debt tranches and equity are first in line to absorb any losses. CLOs are actively managed by specialist CLO managers who oversee loan selection, trading in compliance with portfolio guidelines and tests (including for over-collateralisation and interest coverage which can help ensure structural integrity for investors).

No defaults in AAA and AA tranches in the 1993-2025 period

A CLO usually holds hundreds of loans across industries and regions, which can reduce idiosyncratic credit risk. Further, their floating rate nature can minimise interest rate sensitivity. These factors and the coverage/collateral tests mentioned above may have contributed to the limited default history in the debt tranches (see Figure 2a). According to Moody’s Ratings, there have been no principal defaults on Aaa and Aa-rated CLOs in the dataset that starts in 1993. The one default in the A category was a distressed exchange credit event in July 2009. Otherwise, the highest number of impairments has been in the Ba category, with around 2% of CLOs in that tranche impaired since 1993, with an implied loss rate of 1.1% (according to Invesco Private Credit team calculations).

Global market cap. exceeds $1.2trn

In terms of the size of the asset base, the market capitalisation of CLOs included in the JP Morgan US CLOIE indices was US$0.9trn on 30 June 2026 (source: JP Morgan), compared to $1.5trn for the S&P UBS US Leveraged Loan Index (source: S&P UBS) and $1.5trn for the Bloomberg US Corporate High Yield Index (source Bloomberg). As shown in Figure 2b, the AAA tranche dominates the US CLO market, with around 70% of total market capitalisation. In Europe, the market capitalisation of CLOs included in the JP Morgan Euro CLOIE indices was €0.3trn on 30 June 2026 (source: JP Morgan), compared to €0.5trn for the S&P UBS Western Europe Leveraged Loan Index (source: S&P UBS) and €0.4trn for the Bloomberg Pan-European High Yield Index (source Bloomberg). The euro CLO market is also dominated by the AAA tranche, with a weighting of around 66%.

What does history tell us about the performance of CLOs?

Figure 3 compares historical US CLO debt tranche performance with that of other US assets over the 2012-25 period (the furthest back that CLO indices allow us to go). Based on that data, it seems that CLOs present investors with a spectrum of risk-reward possibilities that may be useful in an asset allocation process.

Over the period considered, AAA-rated CLOs have resembled cash (with more return and more volatility). AA and A-rated CLOs been similar to bank loans and have offered higher returns with less volatility than government bonds and investment grade credit (IG). BBB-rated CLOs have resembled high yield credit (HY), while the more volatile BB and B tranches have produced equity-like returns. Figure 4 shows the calendar year ranking of CLO tranches, with the inverse relationship between credit quality and returns surprisingly consistent (2022 is perhaps the best example of a year when quality was rewarded). 

There is less data in Europe, but the same principles seem to apply.

Turning to European markets, Figure 5 shows a similar pattern of historical asset returns, though the timeframe is shorter due to data limitations. The period considered is perhaps too short to be considered representative, but the patterns are broadly similar to what has been seen in the US. Notably, returns across CLO debt tranches have been higher in the lower rated segments, but with more volatility. 

Further, the relationship with other asset categories seems to follow the same pattern as in the US: 

• AAA-rated CLO returns most closely resemble those of cash, with higher volatility and higher returns.
• AA and A-rated CLO returns are similar to those of bank loans, though with lower returns.
• BBB-rated CLO returns resemble those of high yield, though with higher returns and lower volatility in Europe (though the volatility was slightly higher in the US).
• BB-rated CLO returns are somewhere between HY and equities.
• B-rated CLO returns resemble those of the equity asset class, giving similar returns with lower volatility in Europe (but higher in the US).

CLOs offer flexibility…

Hence, when looking at historical returns across the Europe and the US, it seems that CLO debt tranches offer a lot of flexibility and could perhaps be used to replicate the returns offered by a broader range of asset categories (from cash to equities).

…exploring their role within diversified portfolios 

The following sections will examine a number of questions, with a focus on the US given the limited European data history:

1. Can certain CLO tranches be used to replace other assets in an asset allocation framework?
   1. AAA-rated CLOs for cash
   2. BBB-rated CLOs for HY
   3. B-rated CLOs for equities
2. Under what circumstance do CLOs perform particularly well/poorly.

Investment risks 

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Many senior loans are illiquid, meaning that the investors may not be able to sell them quickly at a fair price and/or that the redemptions may be delayed due to illiquidity of the senior loans. The market for illiquid securities is more volatile than the market for liquid securities. The market for senior loans could be disrupted in the event of an economic downturn or a substantial increase or decrease in interest rates. Senior loans, like most other debt obligations, are subject to the risk of default. The market for senior loans remains less developed in Europe than in the U.S. Accordingly, and despite the development of this market in Europe, the European Senior Loans secondary market is usually not considered as liquid as in the U.S. The value of investments, and any income from them, will fluctuate. This may partly be the result of changes in exchange rates. Investors may not get back the full amount invested.

Alternative investment products, including private equity, may involve a higher degree of risk, may engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, may not be required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual portfolios, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. There is often no secondary market for private equity interests, and none is expected to develop. There may be restrictions on transferring interests in such investments.