It is incredible. A few days before level III exam, and AF’s “best and brightest’ are deeply engaged in a level I and II terminology. The problem is you are arguing past each other because of confusing terms.
Let’s step back guys.
- OAS modeling ASSUMES that the bond in question is NOT going to be defaulted (at least not for the assumed interest rate volatility). Remember the binary tree used in level II: none of the nodes has default as value. Therefore OAS is good for comparison of (similar) investment grade bonds since those bonds are unlikely to default in standard volatility scenarios.
- Agency MBS has implicit guarantee of the US gov thus assumed to be default-free (or at least investment grade) thus appropriate for OAS modeling.
- Junk bond has high default risk thus not appropriate for OAS modeling.
- OAS is good for comparison between option-free and option-embedded bonds with similar investment graded credit rankings (and between option-embedded bonds even though you’d get same conclusion using z spread) since the OAS ‘removes’ the extra spread one pays for the option (option price) from the z-spread thus make it comparable between bonds with options and bonds without.
The confusion is due to the definition of ‘exclude’
- OAS excludes option risk: OAS removes the option price. All other risks remain (model risk, interest rate risk,…), even though it is not appropriate to address default risk (see below).
- OAS excludes default risk: It actually means the OAS methodology excludes the possibility of default. OAS modeling assumes no default thus does not take default into account. OAS is not appropriate to be used for high risk option-embedded bonds. The OAS number DOES include the default risk, but it is meaningless in the same way as you use DCF model for a start up firm using risk free rate as discount rate (or one may argue that it is inappropriate to use a DCF model for a start up at all).
PS: Paraguay, I agree with you about the credit spread option convention used in the CFAI book. It seems to be opposite with standard industry convention, i.e., CFAI calls “credit spread call” while one would normally call the same option a “credit spread put”.