Unlocking the Potential of CLOs: Why the New Diversified CLO ETF Offers a Strategic Fixed-Income Play

In a world where fixed-income yields remain stubbornly low, investors are increasingly turning to structured credit products to unlock value. Collateralized loan obligations (CLOs) have emerged as a compelling solution, offering a unique blend of high yield, diversification, and credit risk mitigation. The recent launch of the Diversified CLO ETF (ZAAA) has further amplified this opportunity, providing a vehicle to access the senior tranches of CLOs with a focus on active credit selection and structural safeguards.

The Case for CLOs in a Low-Yield Environment

The fixed-income market in 2025 is defined by a paradox: yields are near historic lows, yet demand for income remains robust. Broad fixed-income indexes returned 4.00%–7.25% in the first half of the year, driven largely by coupon incomeActive Fixed Income Perspectives Q3 2025: The power of income^[2], while high-quality municipal bonds offer yields near 5.00%Active Fixed Income Perspectives Q3 2025: The power of income^[2]. However, these returns come with diminishing margins. Investment-grade spreads are tight, and high-yield bonds are expensive, squeezing value from traditional indicesFixed Income Outlook 2025: Sector Picks^[1].

CLOs, by contrast, offer a yield premium. In 2024, median equity distributions in U.S. CLOs reached 16% annually, outperforming the typical 14-15% target for investorsFixed Income Outlook 2025: Sector Picks^[1]. This is due to their structure: CLOs pool floating-rate corporate loans, primarily below investment grade, and securitize them into tranches with varying risk-return profiles. The senior tranches, which the Diversified CLO ETF targets, are rated AAA and offer first-priority claims on cash flows, making them a low-risk, high-yield alternative to traditional fixed incomeFixed Income Outlook 2025: Sector Picks^[1].

Structural Advantages: Diversification and Credit Risk Mitigation

The Diversified CLO ETF's appeal lies in its ability to combine income generation with disciplined risk management. CLOs are subject to strict collateral tests, including the Weighted Average Rating Factor (WARF), Weighted Average Spread (WAS), and diversity tests, which limit exposure to low-rated loans and single-issuer riskCLOs: Superior Performance, LSTA^[3]. These tests ensure that the underlying loan pool is diversified across sectors and geographies, historically resulting in lower default rates compared to similarly rated corporate debtActive Fixed Income Perspectives Q3 2025: The power of income^[2].

Moreover, CLOs employ a subordination structure that acts as a buffer against defaults. For example, in the event of a 50% recovery rate, nearly 25% of the underlying loans would need to default before BBB-rated tranches face principal lossesFixed Income Outlook 2025: Sector Picks^[1]. This layered protection, combined with active management by CLO managers, enhances resilience in volatile markets. As one manager noted, “CLOs are designed to absorb shocks, making them a fortress in a low-yield world”Fixed Income Outlook 2025: Sector Picks^[1].

Strategic Positioning for 2025 and Beyond

The Diversified CLO ETF is particularly well-suited to the macroeconomic landscape of 2025. With the Federal Reserve expected to cut rates later this year and economic growth slowing to 1.5%, investors are prioritizing income generation and duration hedgingActive Fixed Income Perspectives Q3 2025: The power of income^[2]. CLOs, with their floating-rate nature, offer protection against interest rate volatility, while their yield curve steepening potential aligns with Goldman Sachs' recommendation to capitalize on divergent central bank policiesFixed Income Outlook 2025: Sector Picks^[1].

Additionally, the CLO market is expanding. U.S. new issuance is projected to reach USD180-215bn in 2025, driven by middle-market and private credit demandFixed Income Outlook 2025: Sector Picks^[1]. This growth is supported by declining default rates—projected at 2.6% in the U.S. and 2.7% in Europe—and technological advancements that enhance transparency and efficiencyFixed Income Outlook 2025: Sector Picks^[1]. For the Diversified CLO ETF, this means access to a deep and evolving opportunity set.

Risks and Considerations

While CLOs offer compelling advantages, they are not without risks. A liquidity crunch or inflationary spike could stress underlying borrowers, particularly in sectors like retail or consumer discretionary, where some CLO managers have adopted an underweight stanceFixed Income Outlook 2025: Sector Picks^[1]. However, the ETF's focus on senior tranches and active sector rotation mitigates these concerns. As one analyst observed, “The key is to avoid overexposure to cyclical sectors and lean into defensive industries like media and telecom, which are showing stronger momentum”Fixed Income Outlook 2025: Sector Picks^[1].

Conclusion

The Diversified CLO ETF represents a strategic response to the challenges of a low-yield environment. By leveraging the yield advantage, diversification, and credit risk mitigation inherent in CLOs, it offers investors a way to enhance returns without sacrificing safety. As fixed-income markets continue to grapple with macroeconomic dispersion and divergent policy paths, CLOs—and the Diversified CLO ETF in particular—stand out as a vehicle for navigating uncertainty while capturing relative value.