And, Not Or: A Rules-Based Rotation Between CLO Debt and Equity Through Market Cycles
Key takeaways
- CLO activity has clustered at the extremes: investors have focused on top-rated CLO ETFs at one end of the stack or fast-growing CLO equity funds at the other. Few are paying attention to the area between the endpoints.
- In assessing this opportunity, we used historical data to analyze the hypothetical impact of a rules-based rotation between junior debt and equity based on relative performance signals.
- The rotation was contrarian by design. The rule added equity exposure after equity underperformed, not after a run, defying intuition. That discipline helped avoid some of the worst months while still capturing upside.
Executive summary
This paper explores whether a rules-based rotation between CLO equity and sub-investment-grade (IG) CLO debt can achieve a better balance of return and potential downside protection than either sleeve held on its own. Over the 158-month window from April 2013 through May 2026, the rotation produced a 10.5% net CAGR,1Extracted returns are pro forma; no fund investor actually achieved the net return shown. See Disclaimers for extracted return methodologies. captured 92.8% of CLO equity’s positive-month returns while participating in 73.1% of its down-months, and carried a less severe left tail than static sub-investment-grade debt. The strategy shifts between CLO debt and equity based on which has performed better over the prior 12 months. The specific rules for when to switch, how much to allocate, and how long to hold each position are outlined herein. The results suggest this kind of rotation can be a useful factor when deciding how to allocate across the more junior tranches of the CLO capital stack.
The opportunity between CLO market endpoints
Recent CLO product activity has clustered at the two ends of the capital stack. At the top, PitchBook LCD reports that CLO ETF assets rose above $50 billion in the second quarter of 2026, with 95% dedicated to AAA to A tranches. Down the stack, AUM and investor interest in captive CLO equity funds have grown rapidly, as seen in Bain Capital Credit’s successful recent launch of the $1.5 billion CLO Management Fund III (CMV III). Between those endpoints lies a less-examined opportunity to actively allocate between junior CLO debt and equity as market conditions change.
Rotation analysis methodology
We tested a single question: Could an investor have improved the risk-return profile of a lower-stack CLO allocation by systematically shifting between junior debt and equity rather than holding either one, or a fixed mix, throughout the cycle? To answer it, we backtested a rules-based strategy that adjusts the allocation based on the prior 12 months of relative performance between CLO equity and a 50/50 BB/B debt blend. The time period, April 2013 through May 2026, was chosen because it was the first window in which the required debt and equity index series are all available. The analysis uses third-party market data and index-based return estimates from J.P. Morgan and Citi.
Framework attributes
Signal
Twelve-month trailing return spread (CLO equity minus sub‑IG debt blend), standardized against the full history of that spread to date.
Thresholds
z below −1.0 moves to 60% equity weight. z above +1.0 moves to 10% equity weight. Inside the ±1.0 hold range, current weight is held unchanged.
Starting weight
35% equity while signal calibrates (before first valid z‑score). The rule governs thereafter.
Minimum hold
Six months between target-weight changes, reflecting the liquidity profile of the market.
Lag
One-month implementation lag: signal measured end-of-month, weight applied at following month-end.
Costs
15 bp one-way on debt notional rotated and 60 bp one-way on equity notional rotated. Applied only on flip months.
Analysis exclusions
New-issue equity and captive equity fund performance are excluded because they reflect different entry points, cost bases, and arbitrage profiles. The analysis also does not attempt to model the broader set of decisions available to a CLO portfolio manager, including moving up in quality or liquidity, choosing between primary and secondary opportunities, allocating between US and European markets, selecting managers, or taking control positions that may create refinancing optionality.
With these exclusions, the analysis focuses on whether rotating between lower-stack debt and equity adds value on its own.
Why rotation matters in the lower CLO tranches
1. Capital-stack construction
CLO debt and equity are priority claims on the same collateral pool, but their payoff profiles differ materially. Debt tranches receive contractual priority distributions and benefit from credit enhancement, while equity receives the residual cash flows and carries first-loss exposure. Over the 158-month study window, correlations between debt tranches and CLO equity ranged from 0.41 to 0.63, indicating meaningful diversification across the capital stack.
The distinction becomes more pronounced lower in the stack. A BB-rated CLO tranche remains a bond: its upside is capped, while downside can be significant in a stressed market. CLO equity has a wider range of outcomes and can capture greater upside as markets recover, benefiting from improving loan prices during the active trading period and wider reinvestment spreads against largely locked-in CLO liabilities. The allocation question, therefore, is which part of the capital structure offers the most attractive risk-adjusted return at a given point in the market cycle.
2. March 2020 and downside behavior
The March 2020 decline was severe but brief, with the largest drawdowns since the Great Financial Crisis (GFC). A portfolio that held only lower-rated CLO debt, represented by a 50/50 mix of BB and B tranches, lost 53.2% from peak to trough during the March 2020 selloff. True to those bond characteristics, upside remained limited while downside proved significant as loan spreads widened, prices fell sharply, and liquidity deteriorated.
CLO equity also marked down sharply during the selloff, but its return profile was different. While lower-rated debt repriced directly as credit spreads widened and prices moved further below par, CLO equity retained greater upside to a recovery in loan prices and the opportunity to reinvest at wider spreads. As a result, the BB/B debt index ultimately fell further than the equity return estimates used in the analysis.
The rotation entered the March 2020 selloff at its equity ceiling, so it held the part of the stack that retained more recovery participation. As is common in many severe drawdowns, and as also seen in the 2015-2016 energy selloff, the recovery can be nearly as rapid as the shock itself, and capturing it requires already holding the position.
The rotation finished calendar 2020 up approximately 31%, which converts the deepest drawdown into the framework’s strongest year. As seen in Exhibit 3, the downside path is also less severe.
3. CLO equity up- and down-market capture
The rotation rule increases its equity weight after equity underperforms debt and shifts toward debt after equity’s relative return moves above the upper threshold.
Over the full window, the rotation captured 92.8% of the returns in CLO equity’s 97 positive months and 73.1% in its 61 down months. The difference between positive-month capture and down-month participation was a full 19.7 percentage points.
4. How the signal behaved in practice
Across the full 158-month analysis window, the framework made one initial allocation and six subsequent rotations. Exhibit 5 shows when those shifts occurred and how the implemented equity weight changed over time.
As of May 2026, CLO debt had out-earned CLO equity on a trailing basis since 2023, which the contrarian signal treated as a relative dislocation. The allocation was kept at its 60% equity bound. This is similar to the trend seen following the 2016 and 2020 relative-return dislocations.
Sub-IG yield backdrop at rotation dates
Month |
Event |
Action |
Equity move (lagged for pacing) |
Sub-IG spread |
Base rate |
All-in yield |
|---|---|---|---|---|---|---|
Nov 2014 |
Start |
Shift toward equity |
35% to 60% |
757 bp |
0.1% |
7.7% |
Jul 2016 |
Signal event 1 |
Shift toward debt |
60% to 10% |
1066 bp |
0.4% |
11.1% |
Jun 2017 |
Signal event 2 |
Shift toward equity |
10% to 60% |
667 bp |
1.2% |
7.9% |
Apr 2020 |
Signal event 3 |
Shift toward debt |
60% to 10% |
1938 bp |
0.1% |
19.5% |
Oct 2020 |
Signal event 4 |
Shift toward equity |
10% to 60% |
1338 bp |
0.1% |
13.5% |
Jun 2021 |
Signal event 5 |
Shift toward debt |
60% to 10% |
951 bp |
0.0% |
9.5% |
Feb 2023 |
Signal event 6 |
Shift toward equity |
10% to 60% |
1181 bp |
4.6% |
16.4% |
Table is included to show the level of all-in yield available in the sub-IG debt market at rotation dates. Source: Citi Velocity, USD CLO 2.0 BB and B spread series and short-term USD base-rate proxy. Base-rate proxy uses SOFR where available and spot LIBOR before SOFR is available. Sub-IG spread is defined as a 50/50 average of BB and B spreads. All-in yield proxy equals sub-IG spread plus base-rate proxy using the most recent available observation on or before each implemented rotation month-end. Shift toward equity means rotating toward CLO equity. Shift toward debt means rotating toward sub-IG debt.
Strategy |
CAGR |
Ann Vol |
Max DD |
Best Month |
Worst Month |
|---|---|---|---|---|---|
Rotation (net) |
10.51% |
19.38% |
−42.1% |
27.13% |
−35.81% |
Static 50/50 |
8.93% |
17.78% |
−43.4% |
17.44% |
−38.39% |
Sub-IG debt |
8.95% |
14.67% |
−53.2% |
29.68% |
−51.32% |
CLO Equity |
7.92% |
22.69% |
−40.0% |
16.95% |
−25.47% |
For illustrative purposes only. Source: J.P. Morgan CLOIE US CLO 2.0 (BB and B debt series) and Citi US CLO 2.0 Equity Estimates, Apr 2013 through May 2026 (158 months). Rotation net of 15 bp debt and 60 bp equity one-way transaction costs. CAGR = geometric annualized return. Ann Vol = standard deviation of calendar-year returns. Max DD = peak-to-trough decline. Volatility is measured on calendar-year returns because CLO equity is valued from estimated, periodically updated marks rather than frequent trade prints, so a monthly measure understates its dispersion.
As a separate analysis, we let the strategy move all the way to 100% debt or 100% equity, rather than limiting how concentrated the portfolio could become. That more extreme approach produced higher returns and a smaller drawdown over the full period, but most of the advantage came from 2020, by far the most unusual and unpredictable period in the sample. Excluding 2020, the more balanced approach delivered both higher returns and a smaller drawdown.
In closing
The results of our analysis suggest investors do not need to choose between junior CLO debt and equity as static allocations. A disciplined rotation between the two can help capture much of equity’s upside while reducing participation in weaker periods, creating a more balanced risk-return profile through the cycle. While hypothetical and based on historical data, the framework suggests that actively shifting between debt and equity can improve how investors manage the lower CLO capital stack.
About Bain Capital Credit
Our flexible and rigorous Credit business is designed to invest across the capital structure and provide bespoke lending solutions to corporate and asset-backed players. With a team of over 120 investment professionals,2Bain Capital Credit professional headcount as of October 1, 2026. including dedicated industry experts with deep vertical expertise, we invest globally in Private Credit, CLOs, loans, multi-asset credit, and asset-based finance strategies. Learn more at baincapitalcredit.com.
Disclaimers
In this material Bain Capital Credit, LP refers to itself and its advisory affiliates. The investment results described herein are presented for illustrative purposes only and do not represent actual fund performance. Past performance is not indicative of future results. There is no assurance that the investment objectives described herein will be achieved.
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Data sources. J.P. Morgan CLOIE US CLO 2.0 monthly total return series for the BB and B debt tranches, used under license. Citi US CLO 2.0 Equity Estimates monthly total return series, used under Bain Capital Credit’s licensed research subscription. The equity series is total return without distribution reinvestment, and rotation returns are constructed on this convention. Citi Velocity for USD CLO 2.0 BB and B spread series. New York Fed for SOFR, with spot LIBOR proxy before SOFR is available. Market context for CLO ETFs and captive equity funds is based on PitchBook LCD, Q2 US CLO Wrap (June 29, 2026) and Captive equity boom rewrites rules for CLO and loan markets (May 21, 2026). Full analysis window is April 2013 through May 2026 (158 months), the first month in which the required debt and equity series are all available. Index returns are not directly investable.
Methodology notes. The valuation signal uses an expanding-window z-score with a minimum six-month history, computed on J.P. Morgan CLOIE debt series and the Citi US CLO 2.0 Equity Estimates series. The rotation backtest uses US BB and US B CLOIE debt series to preserve a single US index framework. European single-B CLO debt may provide useful lower-stack market context, but is not substituted into the backtest given the shorter available history and cross-market basis. The target weight is carried forward when the z-score falls inside the +/-1.0 hold range. Rotation bounds are 10% equity and 60% equity. The starting weight prior to signal calibration is 35%. A six-month minimum hold and one-month implementation lag are applied throughout. Exhibit 5 plots the one-month-lagged signal on the implemented month for visual alignment. Annualized returns are geometric (CAGR). Annualized volatility is the standard deviation of calendar-year returns. Maximum drawdown is the largest peak-to-trough decline in a growth-of-$100 series. Supporting workbook available on request from Bain Capital Credit.
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Hypothetical and backtested performance
The rotation results shown throughout this paper are hypothetical and backtested. They were derived by applying the rules-based framework described herein to historical J.P. Morgan CLOIE and Citi CLO 2.0 equity index series over April 2013 through May 2026; no account or fund actually traded this strategy over this period, and no investor achieved the returns shown. The results reflect the benefit of hindsight in the selection of the rule parameters, are net of estimated transaction costs only (15 bp debt and 60 bp equity, one-way) and reflect no management or incentive fees, and are not indicative of future results. Index returns are not directly investable.
Notes regarding pro forma investment returns
Certain information herein reflect estimates, opinions, or predictions based on Bain Capital Credit’s models or the judgment of Bain Capital Credit investment professionals, which may change in the future. There is no guarantee that such estimates, opinions or predictions will be realized.
Some of the performance information presented in this presentation is pro forma and includes assets held in various Bain Capital Credit funds and separately managed accounts. Those funds and accounts also held other investments and no fund or account investor actually achieved the returns shown in this presentation. In addition, the pro forma information does not take into consideration any leverage that may have been used. These pro forma performance results may have inherent limitations, including that they are prepared with the benefit of hindsight. These are provided for illustrative purposes only, and no representation is made that any investor will or is likely to achieve returns similar to those shown. The information contained herein is unaudited, subject to change, and is provided for informational purposes only. Other performance calculations may produce different results.
Returns are calculated in local currencies and then rebased into a single currency as though perfectly hedged.
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