CLO AAA: Why Investors Still Hold Them in Their Portfolios

In a cycle of falling rates, short duration isn't out of the game yet

The temptation is familiar: when the Fed starts lowering its benchmark rates, investors rush to long-term bonds, hoping to capitalize on the appreciation of bond prices as yields ease. However, as managers John Kerschner, Nick Childs, and Jessica Shill remind us, this reflex can be counterproductive.

Historically, long-term yields start to drop even before the Fed begins its easing. The current cycle is no exception: the 10-year US Treasury yield, which had reached 3.62% in September 2024, fell back to about 4.1% by November 2025. In other words, much of the expected easing is already priced in. For long-term bonds to significantly outperform, a recession or a sharper-than-expected drop in inflation would be required—two scenarios the market no longer views as central.

Conversely, short-term rates are expected to gradually decrease over the coming months: futures now reflect a cumulative decrease of about 78 basis points over a year, which would bring the effective Fed Funds rate to around 3%, down from the current 3.87%. In such an environment, maintaining a short-duration position isn't a tactical error; it's a way to stay flexible, protected against potential increases in long-term rates (via high term premiums), and positioned in a segment that continues to offer attractive yields.

The managers also highlight a frequently overlooked point: as short-term rates decline, the spread—the additional income above the risk-free rate—becomes the crucial component of total return. This is precisely where AAA-rated CLOs find their relevance.

Why AAA-rated CLOs Consistently Outperform in This Type of Environment

Collateralized Loan Obligations (CLOs) are often misunderstood: they suffer from a complex image, yet their AAA tranches—the highest rated—historically demonstrate better credit quality than short-term investment-grade corporate bonds. Moreover, they offer a higher yield.

Between 2015 and 2025, AAA CLOs provided an average spread of +140 basis points over the risk-free rate, compared to 56 basis points for short investment-grade bonds, and 0 points for money market funds. As interest rates decline, this income component becomes predominant: at zero rates, money market funds yield nothing, while AAA CLOs continue to distribute their spread.

This dynamic explains their cumulative outperformance over ten years, as illustrated by the data: AAA CLOs show a total return higher than that of short-term investment-grade bonds and cash equivalents.

Another structural advantage is that AAA CLOs require less of a stable interest rate environment to deliver performance. Their floating coupon adjusts with rate decreases, while the spread remains largely intact, offering a steady income profile. Contrary to some investors' fears, this outperformance doesn't come with excessive risk: at the index level, the credit quality is actually higher than that of short-term investment-grade bonds.

The data also highlight an instructive precedent: during the rate-cutting cycle of 2019, AAA CLOs continued to generate positive returns despite three successive rate cuts by the central bank. Short-term investment-grade bonds performed slightly better, but with higher volatility, which tempers their advantage.

Finally, the relatively low correlation of AAA CLOs with other bond segments makes them attractive for diversification. Simulations show that including AAA CLOs in a portfolio representative of the U.S. Aggregate Bond Index would have improved risk-adjusted performance, combining higher yield with a lower standard deviation.

Balancing Yield, Credit Quality, and Low Correlation: An Asset That Remains Relevant in 2025–2026

According to the authors of the analysis, the conclusion is straightforward: in a context where investors want better returns than cash equivalents without taking on excessive risk, AAA CLOs present a coherent option.

They offer:
– higher income than short-term investment grade,
– robust credit quality,
– contained volatility,
– and relative protection if long-term rates rise rather than fall.

Contrary to intuition, the best bond strategy is not necessarily to extend duration when the Fed cuts rates. In an environment of a slowdown without a recession, high fiscal deficits, and residual inflation, short-term but well-compensated assets can play a major stabilizing role.

AAA CLOs, in particular, meet these criteria precisely.