The Strategic Case for AAA CLOs in a Slower Rate-Cutting Environment

In the wake of the 2024 U.S. election and the Federal Reserve's anticipated slower rate-cutting trajectory through 2025 and 2026, income-focused investors face a critical juncture. With cash yields near zero and short-duration corporates offering modest spreads, the search for resilient, high-quality assets has intensified. Amid this backdrop, AAA collateralized loan obligations (CLOs) emerge as a compelling solution, combining structural credit protections, consistent income, and diversification benefits that outperform traditional alternatives.

Credit Quality and Yield: A Superior Alternative to Cash and Short-Duration Corporates

AAA CLOs, the most senior tranches of structured debt backed by portfolios of senior secured corporate loans, have historically delivered robust credit spreads. From January 2015 to January 2025, AAA CLOs generated an average of 142 basis points (bps) over the risk-free rate, compared to just 69 bps for short-duration investment-grade (IG) corporates and 0 bps for cash/money market funds. This spread advantage becomes even more pronounced in a slowing rate-cutting environment, where the income from AAA CLOs remains stable while cash yields stagnate.

The structural design of AAA CLOs amplifies their appeal. These instruments benefit from a layered capital structure, with subordinated tranches absorbing initial losses, ensuring senior AAA tranches remain insulated. Historically, no AAA CLO has defaulted, and the asset class has demonstrated low volatility, with drawdowns typically recovering within one to two quarters—far outperforming the fragility of short-duration corporates during market stress.

Diversification and Resilience: A Hedge Against Macroeconomic Uncertainty

As central banks pivot toward cautious rate cuts, portfolios must prioritize assets that balance yield with risk mitigation. AAA CLOs, with their floating-rate structure and diversified loan collateral, offer natural protection against interest rate fluctuations. During the March 2020 market turmoil, AAA CLOs experienced a -10% drawdown, significantly smaller than the declines seen in other fixed-income sectors. Their low correlation to equities and traditional bonds further enhances their diversification value.

The growing CLO ETF market has made these benefits accessible to a broader range of investors. However, not all CLO ETFs are equal. Funds like the Janus Henderson AAA CLO ETF (JAAA) exemplify how active management can optimize risk-adjusted returns.

Active Risk Management: Leveraging Dislocations for Enhanced Returns

JAAA, which holds 390–404 North American CLOs, has demonstrated agility in navigating market dislocations. During the April 2025 selloff—triggered by fears of aggressive Fed rate cuts—the ETF faced a record $600 million outflow in a single day. Forced to liquidate $220 million of CLO holdings, JAAA's share price traded at a 1.1% discount to net asset value (NAV), a rare deviation. Yet, the fund's structural safeguards—such as first-pay protections and overcollateralization—ensured its underlying assets remained fundamentally sound.

JAAA's active management also prioritizes shorter-dated CLO maturities (3–7 years), aligning with the anticipated gradual rate cuts. This approach minimizes interest rate sensitivity while preserving yield. With a 3.21 Sharpe Ratio and 4.11 Sortino Ratio, the ETF outperforms peers in risk-adjusted returns, despite a modest daily volatility of 1.81%.

Investment Implications: A Strategic Allocation in a Slower Rate-Cutting Cycle

For investors, the case for AAA CLOs is clear. In a slower rate-cutting environment, these instruments offer:
1. Portfolio Resilience: Structural protections that limit downside risk during market stress.
2. Yield Optimization: Higher spreads than short-duration corporates or cash, with floating-rate income stability.
3. Active Risk Management: ETFs like JAAA capitalize on dislocations to enhance returns while maintaining credit quality.

A balanced strategy could pair 60% of a portfolio in AAA CLOs (or active CLO ETFs) with 40% in T-Bills for liquidity, leveraging the strengths of both asset classes. As the Fed's rate-cutting pace moderates, this approach positions investors to capture rising CLO yields while mitigating volatility.

Conclusion: Embracing AAA CLOs for a New Era of Fixed Income

The post-2024 election landscape demands a rethinking of fixed-income strategies. AAA CLOs, with their superior credit quality, consistent income, and diversification benefits, are uniquely suited to thrive in a slower rate-cutting environment. By integrating active CLO ETFs like JAAA, investors can further enhance risk-adjusted returns while navigating macroeconomic uncertainties. As the Federal Reserve inches toward its cautious trajectory, AAA CLOs stand out as a strategic cornerstone for resilient, yield-focused portfolios.