Alternative Credit Awards 2025
20-Nov-25Comprehensive Analysis of CLOs: Structure, Risks and Opportunities
26-Jan-26Alternative Credit Awards 2025
20-Nov-25Comprehensive Analysis of CLOs: Structure, Risks and Opportunities
26-Jan-26Insights
Are investors mispricing
"tail" volatility in AAA CLOs?
Miguel Ramos Fuentenebro
Co-Founder and Partner
While investors overwhelmingly choose highly rated corporate bonds for fixed income investments, they may be overestimating the volatility and risk of AAA CLOs, forfeiting the enhanced return potential and proven stability of these instruments over AA corporates.
AAA CLOs trade at a persistent spread premium to highly rated corporate bonds, which investors seem to ascribe, among other factors, to the need to compensate for episodic tail-volatility events.
Day-to-day behaviour: tighter centres, higher carry
The chart below shows the distribution of daily returns for European AAA-rated CLOs, as represented by the widely followed CLO index from J.P. Morgan (JPM CLOIE EUR Index), and AA-rated corporate bonds (given the lack of AAA-rated corporate bonds). The histogram clearly shows a taller, narrower distribution for AAA CLOs.
The following table1,2 shows descriptive statistics for both series:
AAA CLOs’ mean returns are higher and more stable than those of AA-rated corporate indices. Some investors, however, may consider that the premium is less due to compensation for everyday volatility and more due to compensation for rare, very volatile days.
Tails: infrequent, yet large, driven by price discovery
The following chart zooms in on the low-probability tails of the distribution of daily returns for EUR AAA CLOs and EUR AA-rated corporate bonds.
This chart highlights how daily returns for EUR AAA-rated CLOs show an extremely narrow peak, with very rare large tails. The large tails are due to a few outliers tied to specific days. As a result, we believe that volatility perception may be inflated: investors see the tails and assume persistent risk, but returns on most days are very stable.
To highlight this behavior, we have calculated the percentage of occurrences for different daily return buckets:1,2
Across nearly 2,000 trading sessions since the CLO index was launched in 2018, 93% of EUR AAA CLO daily changes were smaller than ±0.10%, compared to 58% for the EUR AA corporate index, and over 80% of daily returns for the EUR CLO index were under ±0.05%, compared to 34% for the EUR corporate index.1 This confirms the AAA CLO market is calm almost every day, punctuated by only a handful of volatile sessions.
By contrast, EUR AA corporates display larger mark-to-market movement, with over 12% their days above ±0.25%, compared to 2% for the EUR AAA CLO index.2 Only in extreme, “isolated dislocation days”, with absolute movements above ±1% do the EUR AA corporate index and EUR AAA CLO index share a similar number of occurrences, 5 days out of 2000+ for the EUR AAA CLO index and 6 days out of 2000+ for the EUR AA corporate index.
We believe this data shows that AAA CLO tail days tend to be driven by heightened volatility in broader markets (for example, March 2020) rather than any CLO-specific concerns. In such moments, the CLO market benefits from a strong liquidity channel through direct investor-to-investor trading via “bids wanted in competition” (“BWIC”) processes. These competitive auctions provide genuine, same-day market-clearing prices and contribute to the transparency of CLO indices and valuations.
Maximum drawdowns and recovery speeds
Both AAA CLOs and AA corporate bonds in Europe experienced their sharpest one-day declines in March 2020. The episode serves as a useful stress test for comparing how each market behaves under extreme conditions.
A closer look at the data shows that while European AAA CLOs registered more pronounced single-day drawdowns at the height of the dislocation, these moves were short-lived. In contrast, European AA corporate bonds exhibited smaller but more persistent declines. From an investor’s perspective, this suggests that AAA CLO volatility tends to be episodic and self-correcting, whereas corporate bond volatility can linger, extending the duration of drawdown periods.
Why spreads stay wide:
A "tail premium" that looks miscalibrated
Historically, investors have justified the wider spreads on AAA CLOs relative to similarly rated corporate bonds on three main grounds:
- Liquidity concerns, particularly the ability to trade during periods of stress
- Perceived structural or analytical complexity of the CLO asset class, and
- Higher volatility compared with investment-grade corporates.
Over time, greater understanding of the first two factors has made them less of a concern. Investors increasingly recognise that the CLO market benefits from an additional layer of liquidity through BWIC processes, which provide transparent, trade-based price discovery even if dealer balance sheets are constrained. Similarly, the perception of structural complexity has diminished as specialist managers, such as Fair Oaks, have helped investors better understand the asset class, supported by dedicated teams and proprietary analytics.
The final justification, higher volatility, appears increasingly inconsistent with the evidence. As this analysis shows, AAA CLOs exhibit tighter daily return distributions and faster recoveries after stress events than their corporate peers. In other words, the market continues to price a “tail premium” for volatility based largely on perception rather than evidence.
We believe this miscalibration presents an opportunity. European AAA CLOs combine this lower volatility with strong structural protection and stable carry, offering investors in European debt high-quality income that compensates well beyond their true risk profile.
Endnotes
- JP Morgan and Fair Oaks data as at 04-Nov-25. European AAA CLOIE Cumulative Total Return Index. Time period of analysis: 29-Dec-17 – 04-Nov-25.
- JP Morgan and Fair Oaks data as at 04-Nov-25. European AA Corporate Bond Total Return Index. Time period of analysis: 29-Dec-17 – 04-Nov-25.
