Rising Demand Drives Innovation in CLO Mezzanine Investment Strategies

Demand for CLO mezzanine tranches has reached new heights in 2025. Liability spreads have approached record tights in the primary, while in the secondary market, certain profiles of CLO mezz have traded at higher prices than triple-A CLO debt for the first time. Meanwhile, Octus’ analysis of CLO tranche pricing reveals that new issue mezzanine spreads were more volatile in the April volatility following the first tariff announcements than spreads on CLO tranches originating from reset transactions.

In response to growing investor demand, the CLO market has undergone a wave of structural innovation in recent years, particularly within the mezzanine tranches. Rated between triple-B and single-B, these tranches offer enhanced yields that appeal to a broadening range of investors, from insurance companies and reinsurance firms to hedge funds and asset managers seeking to optimize book yields in a higher-for-longer rate environment.

“Absent major recession risks or a material slowdown, CLO fundamentals continue to hold up,” said Komal Shahzad, senior vice president responsible for CLO tranche investing at PineBridge Investments. “So it obviously makes a lot of sense to not only clip that coupon but also enhance the book yield.”

One result of this demand has been the widespread adoption of split triple-B structures, which separate the typical flat triple-B tranche into senior and junior components. This configuration had gradually become the new structural norm in U.S. BSL CLOs by 2024, now appearing in 78% of new issues and 83% of resets YTD.

The junior triple-B tranche is typically structured with approximately 11% to 12% par subordination, allowing part of what would have been a double-B-rated tranche at 8% sub to qualify for investment-grade designation, making it attractive to insurance accounts seeking enhanced yield while remaining within the investment-grade mandates, according to Gavin Zhu, head of U.S. CLO research at Barclays.

However, this structure introduces new complexities when it comes to reset execution. According to Pratik Gupta, head of CLO research at Bank of America Securities, split triple-B tranches can reset just as readily as flat triple-B tranches, provided the portfolio performance remains strong.

“In underperforming portfolios, the junior triple-B can be much harder to reset,” Gupta said. “It’s far more susceptible to downgrade risk,” and this can make it challenging to achieve a triple-B rating in weaker resets. In that instance, the CLO might revert back to a regular triple-B and double-B structure.

Trade Tensions

To gauge how the market is pricing this structural innovation, Octus’ CLO data tracks new issue and reset spreads for senior triple-B, junior triple-B and double-B tranches priced in 2025, all featuring five-year reinvestment periods and two-year noncall protections, shown in the charts below.
 

 

As illustrated by the trendlines, CLO mezzanine tranches have generally priced wider in resets than in new issues for most of the year. However, from early March to mid-May – amid the heightened policy uncertainty and tariff rhetoric – this relationship temporarily reversed, with new issue spreads trending above resets across all three rating bands. As the post-“Liberation Day” volatility subsided in mid to late May, spreads realigned, and new issues resumed pricing inside of resets.

Meanwhile, new issue mezzanine tranches have exhibited greater spread volatility than resets over the period, as measured by the coefficient of variation, a normalized metric that compares the standard deviation of spreads with their mean. As shown in the table below, senior triple-B tranches exhibit a coefficient of variation of 13.41% in new issues versus 9.58% in resets, while junior triple-Bs followed at 11.89% and 10.52%, respectively. Double-B tranches posted the highest volatility overall, at 17.85% for new issues and 14.85% for resets.
 

The wider spreads for resets underscore the challenges tied to tail exposure.

“Clean new issues will typically price tighter than reset transactions at almost every tranche level. Generally, the basis between new issues and resets is correlated with portfolio quality, and that basis increases as you move down the capital stack,” said Steve Page, structured credit trader at Barings.

Managers and equityholders often face a tradeoff when preparing a reset. They can either retain weaker loans, so-called tail risk, or sell them off to clean up the portfolio, often at a discount to par.

“All else equal, you are going to get better reset execution on the CLO liabilities backed by the cleaner loan portfolio,” Page noted.

This dynamic also introduces selection bias: Higher-quality portfolios are more likely to reset, partially explaining the lower spread volatility in those tranches.

While tail risk is most concentrated in double-B tranches, it can also offer alpha opportunities.

“Clean new issue double-B currently prices around 500, versus a reset where you might be able to pick up a similar quality bond and earn an extra 50 or 75 bps,” Page noted. For managers with strong credit underwriting capabilities, selectively adding double-B reset tranches could unlock meaningful spread pickup.

Blood, Sweat and Tiers

Shahzad at PineBridge also noted that reset deals have become much “richer” as a highly liquid and active secondary market has pushed valuations higher.

“The basis keeps widening right now,” Shahzad said, emphasizing the divergence between tighter secondary spreads and the primary pricing. She noted that this has resulted in many fast-money buyers “literally just flipping the primary market,” purchasing tranches at issuance and quickly selling them in the secondary for a profit.

CLO manager tiering also contributes to the higher spread volatility observed in new issue tranches. Since resets are typically more viable for higher-tier managers, they tend to exhibit lower spread volatility, especially in the mezzanine part of the capital stack.

Jessica Shill, portfolio manager at Janus Henderson Investors, told Octus that Janus Henderson’s internal manager tiering methodology is highly quantitative.

“On the bond level, we run all outstanding CUSIPs from triple-A through single-B in the U.S. CLOs on a monthly basis and analyze 100 to 130 different metrics on each bond,” Shill explained. “On the manager level, we will track if the manager is starting to have some performance slip, and given it being negative or positive, we will determine whether to re-tier or not, and how we should tier them as we put them into the CLO space.”

Janus Henderson manages the market-leading triple-A CLO exchange-traded fund, or ETF, the $23.34 billion JAAA fund, as well as the $1.36 billion JBBB, which focuses on mezzanine tranches. Late last year the manager launched its EUR AAA CLO UCITS ETF, its first ETF to make investments in European CLOs.

Janus Henderson’s internal manager tiering methodology becomes increasingly important further down the capital stack, where market liquidity offers less guidance. While broader market tiering at the triple-A level tends to reflect brand reputation and trading depth, mezzanine tranches are more directly influenced by credit quality.

“For example, the money of some large Japanese banks might heavily influence the pricing of the triple-A tranches, but it will be less correlated to the triple-B and double-B tranche pricing,” Shill explained. Because of this different approach of manager tiering, some large managers whose holdings are quite large in JAAA might not have exposure in JBBB.

The tight loan market is also complicating the CLO portfolio ramping. According to Page at Barings, ramping portfolios in the secondary market is challenging because many loans are trading above par. Compounding the challenge is the elevated refinancing risk from borrowers. This dynamic forces CLO managers to rely more heavily on the limited primary loan market, and this may slow the ramp process and, in turn, complicate the timing of a CLO issuance.

“If you want to do upsize for a reset, you typically have a two- to three-week price-to-close window on the liabilities, so you do have some buffer there to try to get some new issue into the portfolio,” Page explained.

In contrast, new issue CLOs offer longer settlement windows, typically about six weeks, giving managers more flexibility to accumulate loans. However, with primary issuance pacing slower than demand, managers often must weigh credit quality, pricing and timing more carefully.

The shorter price-to-close window for a CLO reset can shorten the window of capital underdeployment, but underwriting discipline still takes priority. “We are never going to trade a three-week settlement period to buy something that’s super risky just for the sake of saving three weeks,” Page added.

In such a tight loan market, one structural advantage of CLO resets is that the portfolios are already fully ramped, providing investors with greater transparency into the underlying collateral. In contrast, new issue deals often introduce higher risks tied to timing of the ramping post pricing.

“Sometimes reset deals, despite being more seasoned, can look more attractive because new-issue portfolios, while seemingly clean, can end up looking very different from the indicative portfolios,” Shahzad said. “Especially when CLO arb feels stretched.”

The ETF Factor

CLO ETFs, especially those investing in mezzanine tranches, can face heightened cash drag due to liquidity requirements associated with daily redemptions. To meet these demands, funds often maintain larger allocations to more liquid assets or cash equivalents.

William Sokol, director of product management at VanEck, explained how his firm manages cash drag in the VanEck AA-BB CLO ETF, or CLOB, which is sub-advised by PineBridge Investments.

“We view triple-A holdings as cash-like, so we don’t feel that the fund needs to hold significant levels of cash to satisfy redemptions,” Sokol said. He noted that CLOB maintains a minimum 40% allocation to triple-A and double-A tranches, and said that PineBridge may occasionally add small amounts of T-bills, particularly in today’s higher-for-longer rate environment, where their yields make sense for the fund’s liquidity profile.

Janus Henderson’s JBBB employs a similar strategy, using senior tranche exposure to help mitigate cash drag. Jessica Shill told Octus that JBBB can invest up to 5% in JAAA under its structural guidelines. “We have that JAAA item well positioned to help minimize that cash drag of these newly issued mezz bonds,” she said.

Because mezzanine tranches in reset CLOs often offer wider spreads due to higher tail risks, the investment team needs to conduct deeper diligence before committing capital. “If we are not comfortable with the reset, we are going to play the new issue … and this can have a bit more of that cash drag,” Shill said.

This is where JAAA holdings play a critical role, offering a more liquid and yield generating alternative during periods of “waiting.” It allows the team to stay invested while carefully selecting the right mezzanine bonds that suit the fund’s daily liquidity mandate. “The last thing you want to be doing is chasing a few extra basis points for funds that are maybe closed-ended and don’t necessarily fit that daily liquidity vehicle profile very well,” Shill added.

Page at Barings noted that most CLO liabilities, from triple-A down through triple-B, are now trading above par in the secondary market, introducing negative convexity across the upper capital stack. Bonds trading at a premium offer limited price appreciation, since their higher coupons incentivize managers to exercise the call option and redeem them at par, resulting in downside risk for investors who paid above par. “To the extent that you’re buying these at premiums and they don’t get called, that might actually be the upside scenario for you,” Page said.

By contrast, some double-B tranches still trade below par and exhibit positive convexity, offering greater upside potential if spreads tighten or the bonds are called. But Page cautioned that this convexity often comes with higher tail risk.

“We’re talking about a loan market that has stayed pretty bifurcated,” Page said. “You have 60% of loans trading above par, but you still have a tail that sort of gets stuck, and it’s hard to see them rebound.”

Many CLO managers, Page added, avoid adding these distressed names at deep discounts because of the possibility that such credits could get marked to market within the CLO structure as well as the reputational risk of getting those picks wrong.

Meanwhile, tight loan spreads have pushed up market value overcollateralization, or MVOC, and equity net asset value, or NAV, as noted by Shahzad at PineBridge. With the elevated prices across lower-quality B3/B- rated names, “It’s honestly a call for de-risking your portfolios,” Shahzad said. This more technically driven market valuation, in absence of significant fundamental improvement, could pose additional risks for the junior debt tranches.

When assessing value in mezzanine tranches, Barings’ Page pointed out, investors should analyze how much of the loan portfolio’s spread actually accrues to each tranche. “Ask yourself questions like: What’s the pickup you get from moving down a tranche?” Page said. “Does that seem worth it for the extra credit risk and reduced structural protection you’re taking on?”

Still, Shill at Janus Henderson said she believes the CLO market will remain “somewhat self-correcting.”

“We’ve seen over time that even when the arbitrage gets to the fifth percentile level of tightness, managers would still find creative ways to sell the equity and print a new issue deal, albeit volumes will come down,” Shill said.

Hitting Reset

One factor supporting activity has been the ample supply of reset-eligible deals. Shill noted that managers are nearly through resetting deals issued in 2023, and that this cohort included many deals from the 2021 vintage that were already reset once previously. “This was entirely issued before the LIBOR-to-SOFR transition, so all these margins have reset 26 bps wider,” she explained. “This is why these deals are much more in the money for refi and reset.”

Jon Siatkowski, the former head of CLO capital markets at Marathon Asset Management, told Octus that much of the current reset activity is being driven by compressed equity returns. These deals were originally priced during a period of elevated liability spreads and high cost of capital, resulting in annualized equity returns of just 8% to 9%, which is, in some cases, lower than the current yields on triple-B tranches within the same structures.

“These deals are highly incentivized to see that a reset is executed,” Siatkowski said. “They are highly focused on rapid execution to ensure they lock in that new cheaper cost of capital as quickly as possible after the noncall date.”

Given this dynamic, they are not necessarily as sensitive to the widening of their primary market basis for a reset as opposed to a new issue, and this may be inhibiting triple-A tightening in the primary market, as noted by Siatkowski.

Shahzad at PineBridge noted that the current resets are mainly “print and clear” without a large equity injection, and the deals may get leveraged up to a degree that the reset expenses can be covered.

With some managers having already reset these 2021 vintage deals once again ahead of their end of reinvestment period in 2026, and with the 2023 reset pipeline nearing exhaustion, many investors say they believe that more capital injection will be required to make future resets viable.

For mezzanine tranches, however, the impact of increasing reset complexity is relatively nuanced, as the real constraint lies at the top of the capital stack.

“The manager has to focus on the economics of getting that triple-A tighter and then working on the rest of the cap stack,” Shill said. Since the triple-A tranche is the largest and therefore the most expensive part of the structure, she noted, reset economics are ultimately governed by how tightly the triple-A can be placed.

Page at Barings said that the reset decision is not always purely about liability pricing, noting that in some cases, managers may accept similar or even wider liability spreads than the original deal in exchange for extending the reinvestment period, which can provide valuable opportunities to “take advantage of future loan volatility.”

With investors demonstrating a risk-on appetite for CLO mezzanine debt, market participants will need to remain wary of complacency. “Honestly, everything is kind of priced to where there’s nothing that’s going to go wrong, so the broader macro risks for the most part are not being priced in,” said Shahzad.