CLO Mezzanine Debt and Equity: Navigating Structural Resilience and Liquidity in a Stressed Credit Market

In a credit market defined by macroeconomic uncertainty and policy-driven volatility, Collateralized Loan Obligations (CLOs) have emerged as a compelling asset class for investors seeking yield and structural resilience. While the equity tranches of CLOs remain the most volatile, the mezzanine segment—encompassing triple-B to double-B rated tranches—has demonstrated a unique combination of yield, liquidity, and structural innovation that positions it as an undervalued opportunity in 2025.

Structural Resilience: The Split Triple-B Revolution

The mezzanine tranches of CLOs have long been prized for their ability to balance risk and return, but recent structural innovations have amplified their appeal. The widespread adoption of split triple-B structures—where the traditional flat triple-B tranche is divided into senior and junior components—has redefined risk distribution. By subordinating the junior tranche by 11–12%, these structures allow the senior portion to retain investment-grade ratings, attracting capital from insurance companies and other regulated entities.

This innovation has not only broadened the investor base but also enhanced the resilience of mezzanine tranches during resets. For instance, 78% of new-issue U.S. BSL CLOs and 83% of resets in 2025 now employ split triple-B structures. However, the junior component remains exposed to downgrade risk in weaker portfolios, creating a nuanced trade-off between yield and credit quality.

Liquidity Improvements: Secondary Market Dynamics

The secondary market for CLO mezzanine tranches has become a critical driver of valuation dynamics. In Q2 2025, certain mezzanine profiles traded at prices exceeding those of triple-A CLO debt—a first in the sector's history. This liquidity surge has been fueled by fast-money buyers flipping primary tranches for quick profits and the growing participation of ETFs like the VanEck AA-BB CLO ETF (CLOB) and Janus Henderson's JBBB.

However, liquidity challenges persist for mezzanine-focused ETFs due to daily redemption requirements. To mitigate cash drag, funds like CLOB maintain 40% allocations to triple-A and double-A tranches, which act as cash-like assets. This structural need for liquidity has inadvertently created a feedback loop: higher-quality mezzanine tranches in reset deals trade at tighter spreads, while weaker portfolios face wider spreads and greater execution risk.

Active Management Potential: Navigating Tail Risk

The mezzanine and equity tranches of CLOs are inherently active management plays. During resets, managers face a critical decision: retain weaker loans (tail risk) or sell them at a discount to clean up the portfolio. This trade-off directly impacts spread volatility and execution success. For example, clean new-issue double-B tranches priced at ~500 basis points in Q2 2025, while similar-quality reset tranches offered an additional 50–75 bps of yield.

Managers with strong credit underwriting capabilities can exploit these inefficiencies. For instance, double-B tranches in reset deals with clean collateral offer meaningful alpha potential, particularly in a tight loan market where primary issuance lags demand. The ability to selectively add these tranches while avoiding weaker portfolios is a hallmark of skilled active management.

Equity Tranches: A High-Risk, High-Reward Proposition

While the focus remains on mezzanine tranches, the equity segment (single-B) has shown relative underperformance in Q2 2025. The VanEck CLO ETF (CLOI) underperformed its benchmark by 13 bps, and the equity tranche widened by 11 bps amid macroeconomic stress. However, this widening reflects undervaluation rather than structural weakness.

Equity tranches are inherently volatile, but their potential for outsized returns in a higher-for-longer rate environment cannot be ignored. Investors with a longer time horizon and risk tolerance for volatility may find opportunities here, particularly in portfolios with strong vintage and manager selection.

Investment Thesis: Balancing Yield and Risk

The CLO mezzanine and equity markets in 2025 present a compelling case for investors willing to navigate complexity. Key considerations include:
1. Structural Resilience: Split triple-B structures enhance credit quality while preserving yield.
2. Liquidity Management: ETFs and secondary market activity are reshaping pricing dynamics, favoring higher-quality tranches.
3. Active Management: Selective purchases of reset double-B tranches and disciplined portfolio construction can unlock alpha.

For investors, the path forward involves a disciplined, bottoms-up approach. Prioritize portfolios with strong manager track records, clean collateral, and favorable reset execution potential. While macroeconomic risks persist—particularly around trade policy and rate cuts—the current environment favors a quality-conscious, active strategy.

In a world where traditional high-yield assets trade at stretched valuations, CLO mezzanine debt and equity offer a unique blend of structural innovation, liquidity, and active management potential. For those willing to navigate the complexities, the rewards could be substantial.