CLOZ Tranches and the Rising Risk in BBB-Rated Assets: A Strategic Analysis

A line chart illustrating the performance of the Eldridge BBB-B CLO ETF (CLOZ) from 2023 to 2025, highlighting key volatility metrics and drawdowns during periods of BBB collateral downgrades. The x-axis represents time, while the y-axis shows total returns, with annotations for structural protections and hedging strategies.

Data query for generating a chart: Plot CLOZ's annual total returns (2023–2025), volatility (standard deviation), and drawdowns, overlaying periods of BBB collateral downgrades (e.g., 2020–2022 proxy data). Include benchmarks like high-yield bonds and investment-grade corporates for comparison.

The collateralized loan obligation (CLO) market has long been a cornerstone of credit investing, offering structured access to leveraged corporate loans. However, the rising concentration of BBB-rated assets within CLO collateral pools has introduced new risks, particularly for junior tranches like those held by the Eldridge BBB-B CLO ETF (CLOZ). This article examines how overexposure to BBB-rated loans impacts CLOZ's returns and volatility, evaluates the structural safeguards in place, and outlines strategic hedging and exit strategies for investors navigating deteriorating collateral quality.

Structural Protections and the Resilience of CLOZ

CLOs are designed with credit-enhancing mechanisms to mitigate downside risk, including overcollateralization, interest diversion tests, and active management. These features have historically shielded higher-rated tranches from collateral deterioration. For instance, during the 2020–2022 period, rating agencies downgraded 25% of CLO collateral but only 2% of tranches, with junior tranches bearing the brunt of the impact, according to an RFS paper. This disconnect underscores the role of active CLO management in repositioning collateral pools and the use of qualitative adjustments by rating agencies to preserve tranche ratings, as discussed in the RFS paper.

For CLOZ, which focuses on BBB-B rated tranches, these structural protections have been critical. Modeling suggests that BBB tranches can withstand default rates of up to 10% for newer vintages and 15% for seasoned ones before returns decline, per the RFS paper. Par subordination further cushions CLOZ, as equity and lower-rated tranches absorb initial losses. Assuming a 50% recovery rate, nearly 25% of underlying loans would need to default before BBB tranches face principal losses, according to a KKR analysis. This buffer, combined with diversified loan pools and robust credit testing, has contributed to CLOZ's resilience.

Performance and Volatility: Navigating BBB Overexposure

Since its 2023 launch, CLOZ has delivered strong returns, including an 11.84% total return in 2024 and a 34.89% cumulative return through October 2025, based on FinanceCharts data. However, its performance during the 2020–2022 BBB downgrade period remains opaque due to its recent inception. Proxy data from similar CLOs suggests that BBB tranches experienced heightened volatility during this period, though structural protections limited losses (see the RFS paper). CLOZ's recent drawdown of 5.33% in early 2025 highlights the inherent risks of its collateral concentration (FinanceCharts).

The ETF's volatility metrics-such as a 200-day volatility of 4.52% and a beta of 0.42-indicate lower sensitivity to market movements compared to peers (FinanceCharts). This relative stability is partly attributable to its floating-rate structure and active management, which rebalance portfolios to optimize yield while controlling risk, as noted in a Clarion Capital post. Yet, as BBB collateral faces renewed stress, investors must remain vigilant about potential erosion of these safeguards.

Hedging Strategies for Deteriorating Collateral

To mitigate the risks of BBB overexposure, investors in CLOZ and similar instruments should adopt a multi-layered approach:

1. Leverage Structural Protections: CLOs inherently offer self-healing mechanisms, such as quarterly overcollateralization tests, which allow de-leveraging during stress. Investors should prioritize CLOs with robust structural features and active managers who proactively reposition collateral, as highlighted in the KKR analysis.

2. Diversify Fixed-Income Portfolios: Combining CLOs with high-yield bonds and leveraged loans can hedge against rate cuts or prolonged stress. CLOs' low correlation with other fixed-income assets enhances diversification benefits, per the KKR analysis.

3. Utilize Credit Derivatives: Instruments like credit default swaps (CDS) can hedge specific obligor risks within CLO collateral. For broader protection, investors might consider index CDS on leveraged loan indices, as outlined in the SafeAtlas guide.

4. Monitor Manager Track Records: CLO performance is heavily influenced by manager skill. Investors should scrutinize managers' historical responses to credit stress, favoring those with strong rebalancing and default mitigation strategies, as discussed in the Clarion Capital post.

5. Dynamic Duration Adjustments: Given CLOs' floating-rate nature, investors can adjust portfolio duration to align with interest rate expectations. Shortening duration during tightening cycles can reduce reinvestment risk, in line with the SafeAtlas guide.

Strategic Exit Considerations

For investors facing deteriorating collateral quality, selective exits or sector rotations may be prudent. Older-vintage CLOs with limited reinvestment flexibility and higher Caa/CCC exposure should be scrutinized, according to a PineBridge note. Similarly, CLOs with concentrated industry exposures (e.g., energy, retail) may warrant reduced allocations during macroeconomic downturns.

Conclusion: Balancing Yield and Risk

The CLO market's appeal lies in its yield advantage and structural resilience, but rising BBB risk demands a recalibration of strategies. For CLOZ, the interplay between collateral concentration and structural protections will shape its future performance. Investors must balance the pursuit of income with proactive risk management, leveraging hedging tools and active oversight to navigate an evolving credit landscape. As the market matures, selectivity and adaptability will be paramount to preserving capital and enhancing returns.