Strengthen Your Core With a CLO Tranche Allocation

• We believe core bond portfolios benefit from an allocation to CLO tranches, which can provide attractive yields, diversification, and lower default probabilities compared to similarly rated corporate bonds.

• CLO returns have outperformed those of similarly rated bonds over the past decade and have had lower principal losses relative to corporate debt and other securitized products.1

• Due to their floating-rate nature, CLOs are less interest-rate sensitive, which makes them an effective hedge against inflation and higher-for-longer rates, and CLOs’ structural protections have resulted in extremely low default risk historically.2

• CLO demand remains strong due to high all-in yields, and the prospects for lower corporate taxes, deregulation, and a more favorable M&A environment also support the outlook.

While many investors know that collateralized loan obligations (CLOs) have historically yielded compelling performance, they may not know the full extent of the potential benefits – and how a dedicated allocation to CLO tranches could fortify their core bond portfolios.

This may be especially relevant in the current market environment, where we believe core bond portfolios, which don’t typically include CLOs, can benefit from CLO tranches’ ability to provide attractive yields, diversification, and lower default probabilities compared to similarly rated corporate bonds.

For the past 18 months, we’ve seen traditional fixed income portfolios underperform the benchmark US Aggregate Bond Index as much-anticipated declines in the federal funds rate failed to materialize. Additionally, increased geopolitical risk and economic uncertainty with the new US administration have spurred equity market volatility and widened spreads.

The inclusion of CLOs may also make traditional core bond portfolios more competitive relative to equities. Portfolios that include allocations to CLOs have benefited from CLOs’ higher yield, high Sharpe ratios, and lower drawdown rates versus traditional corporate credit (see charts below). Additionally, with only about 23% portfolio overlap among managers in the US CLO market, investing in a diversified CLO portfolio, in itself, may create a more diversified portfolio.3

What happens when CLOs are added to core bond portfolios?

Adding CLOs as a complement to core bond portfolios has provided better outcomes historically. As the charts below illustrate, adding 10% to 30% allocations to CLOs to both core and high yield bond portfolios results in better risk-adjusted returns, enhanced Sharpe ratios, and lower drawdowns than portfolios constructed of only traditional fixed income investments.

CLOs Belong in Traditional Bond Portfolios

Adding US investment grade CLOs to a core portfolio

10-year statistics

Adding AA-BB rated US CLOs to US high yield portfolio

10-year statistics

Source: Bloomberg, J.P. Morgan. 10-Year Annualized Returns and Volatility as of 31 March 2025. Volatility calculated using monthly returns for the trailing 10-year time period. IG CLOs is the JPM CLOIE IG Index, US Aggregate is the Bloomberg US Aggregate Bond Index, AA-BB CLOs is equal weighted JPM CLOIE AA Index, JPM CLOIE A Index, JPM CLOIE BBB Index, and JPM CLOIE BB Index, and High Yield is the Bloomberg US Corporate High Yield Index. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change. Past performance is not indicative of future results. For illustrative purposes only.

Adding European investment grade CLOs to core portfolio

10-year statistics

Adding AA-BB rated European CLOs to European high yield portfolio

10-year statistics

Source: Bloomberg, JP Morgan. 7.25-Year Annualized Returns and Volatility as of 31 March 2025. Volatility calculated using monthly returns for the trailing 7.25-year time period. IG CLOs is JPM Euro CLOIE IG Index, European Aggregate is the Bloomberg Pan-European Aggregate Index, AA-BB CLOs is equal weighted JPM Euro CLOIE AA Index, JPM Euro CLOIE A Index, JPM Euro CLOIE BBB Index, and JPM Euro CLOIE BB Index, and European High Yield is Bloomberg Pan-European High Yield Index. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change. Past performance is not indicative of future results. For illustrative purposes only.

CLO returns have outperformed similarly rated bonds over the past decade and presented lower levels of principal losses relative to corporate debt and other securitized products.4 Due to their floating-rate nature, CLOs are also less interest-rate sensitive, which makes them an effective hedge against inflation and higher-for-longer interest rates. This is an attractive advantage to investors in diversified fixed income portfolios. Structural protections of CLOs have also resulted in extremely low default risk historically.5

CLOs remain attractive amid market volatility

In a world where interest rates will be higher for longer and credit spreads wider, floating-rate assets remain attractive.

While the Fed initiated a series of rate cuts starting in September 2024, inflation is still above the Fed’s target and the labor market remains robust, though signs of slowing growth are starting to emerge. The Fed has paused further action as it awaits more information on the path of inflation and employment, which may shift following the implementation of tariffs and more robust immigration policies. Market expectations for Fed cuts moved slightly higher in March, with three to four now expected in 2025.

The Fed appears to be in a tenuous position, however, having to balance both sides of its dual mandate of maximum employment and stable prices during a period when stagflation is looking ever more likely. Given the increased prospects for a stagflationary environment, we do not expect the Fed to come to the rescue. At present, our view is that given expectations of sticky or higher inflation, the Fed will likely only start to lower rates if unemployment breaches 5%.

Alongside the escalation of a global trade war, the rally in CLO prices we’ve seen since the lows in fourth-quarter 2022 has cracked, with prices declining across the capital stack in March and through the beginning of April. The average price across all tranches is now below par for the first time since January 2024. Elevated market uncertainty and weaker investor sentiment could lead to more volatility in the short to medium term, but wider spreads lower in the cap stack are starting to look more attractive for longer-term investors. Historically BBB, BB, and B rated CLOs outperform in the years following significant fixed income underperformance, and we expect them to be among the top-performing fixed income asset classes.

As markets have sold off in recent weeks, buying in the secondary market has become much more attractive. That said, buying in the primary market also remains attractive, even when taking spread duration into account. CLO equity arbitrage in 2024 was supported by continued liability spread tightening. While recent volatility has driven CLO debt spreads wider, average loan prices have declined materially from the highs in late January, making CLO creation more attractive. Despite that, high levels of amortization and call volumes resulted in marginally negative net AAA supply for 2024 and flat net supply through first-quarter 2025.

Ultimately, we expect CLO spreads and yields to be attractive under most market scenarios over the next 12 months. Notwithstanding the shorter-term tailwinds, we believe wider spreads are beginning to offer attractive entry points for longer-term investors. However, a robust bottom-up approach to security selection remains key given the significant tail risks to the fundamental backdrop and a market bifurcated between vintages and, relatedly, between deals in and out of their reinvestment periods. Given the dispersion seen in the loan market, certain CLO portfolios holding weaker credits may eventually experience impairments to the lowest-rated debt tranches. As a result, vintage, portfolio, and manager selection remain key.

All told, we believe investors should consider how the attractive yields, diversification, and safety potential of a CLO tranche allocation may strengthen the performance of their core bond portfolios.

To learn more about CLO structures and how they work, read our CLO primer, “Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations.”