OAS and Z spread

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dan5342

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Hi all,
I’m having trouble grasping the z spread and OAS spreads clearly. It seems that a z-spread > OAS means that the issuer has a call option. My confusion is that wouldn’t the lower OAS mean that the bond is discounted at a lower rate, thus a higher present value than without the call option. Why would somebody be willing to pay more when there is a call option?
Thanks in advance and let me know if my explanation needs any clarification.
 
You’re mixing up the spreads: the Z-spread applies to the value of the bond with the option included; the OAS applies to the value of the bond with the option removed. Thus, a higher Z-spread than OAS would say that the price of a callable bond is lower than the price of an identical, noncallable bond.
OAS, as you know, abbreviates Option-Adjusted Spread. The “option-adjusted” part of that phrase means “adjusted for the value of the option”; i.e., with the value of the option removed: it’s the spread that applies to a bond without the option in question.
 
I just wanna say this question is one of the most confusing in curriculum at all.
Is there any mnemonics to remember all this?
 
carbolic wrote:I just wanna say this question is one of the most confusing in curriculum at all.
Is there any mnemonics to remember all this?
Click to expand...
If you want merely a mnemonic, perhaps you could use something like this:
  • Callable bond: lower price than a noncallable, lower OAS than Z-spread
  • Putable bond: higher price than a nonputable, higher OAS than Z-spread
However, I, for one, would prefer understanding why this is true, rather than simply memorizing it. Furthermore, the understanding isn’t all that difficult.
See my post above for why it’s true.
 
Price Suggestion to Mnemonic
Callable lower compared to noncallable CLeaN
Putable lower compared to nonputable PLaiN
Suggestion to Mnemonic
Callable lower OAS than Z-spread CLOsed
Putable lower OAS than Z-spread PLOsed
 
Magician, it makes sense.
Putable bond is more expensive because it gives the bond holder the right to sell, thus an advantage to the bond holder, thus a higher OAS than Z Spread. If we remove this option, the bond holder does not have this benefit, thus the price of the bond drops and yields go up (higher OAS). If we include this option, the spread is lower (price is higher) because the option is an advantage to the bond holder.
 
doobsmeister wrote:Magician, it makes sense.
Click to expand...
Good to hear.
doobsmeister wrote:Putable bond is more expensive because it gives the bond holder the right to sell, thus an advantage to the bond holder, thus a higher OAS than Z Spread. If we remove this option, the bond holder does not have this benefit, thus the price of the bond drops and yields go up (higher OAS). If we include this option, the spread is lower (price is higher) because the option is an advantage to the bond holder.
Click to expand...
Yup.
 
S2000magician wrote:
You’re mixing up the spreads: the Z-spread applies to the value of the bond with the option included; the OAS applies to the value of the bond with the option removed. Thus, a higher Z-spread than OAS would say that the price of a callable bond is lower than the price of an identical, noncallable bond.
OAS, as you know, abbreviates Option-Adjusted Spread. The “option-adjusted” part of that phrase means “adjusted for the value of the option”; i.e., with the value of the option removed: it’s the spread that applies to a bond without the option in question.
Click to expand...
You’re a saviour. Couldnt have understood this better. The mnemonics is the icing. Thank you.
 
S2000magician wrote:
You’re mixing up the spreads: the Z-spread applies to the value of the bond with the option included; the OAS applies to the value of the bond with the option removed. Thus, a higher Z-spread than OAS would say that the price of a callable bond is lower than the price of an identical, noncallable bond.
OAS, as you know, abbreviates Option-Adjusted Spread. The “option-adjusted” part of that phrase means “adjusted for the value of the option”; i.e., with the value of the option removed: it’s the spread that applies to a bond without the option in question.
Click to expand...
To help me engrain this: magician, if most investors are using arbitrage-free valuations, have you experienced that most OAS spreads, all else fixed, are roughly equal? Or, do the different methods of modeling short-term rates cause an OAS spread dispersion?
 
clangerh wrote:
S2000magician wrote:You’re mixing up the spreads: the Z-spread applies to the value of the bond with the option included; the OAS applies to the value of the bond with the option removed. Thus, a higher Z-spread than OAS would say that the price of a callable bond is lower than the price of an identical, noncallable bond.
OAS, as you know, abbreviates Option-Adjusted Spread. The “option-adjusted” part of that phrase means “adjusted for the value of the option”; i.e., with the value of the option removed: it’s the spread that applies to a bond without the option in question.
Click to expand...
To help me engrain this: magician, if most investors are using arbitrage-free valuations, have you experienced that most OAS spreads, all else fixed, are roughly equal? Or, do the different methods of modeling short-term rates cause an OAS spread dispersion?
Click to expand...
I spent the bulk of my time at PIMCO developing prepayment models for mortgage-backed securities. The objective was to determine for ourselves the correct OAS, rather than rely on OAS estimates from outside sources (e.g., Bloomberg). Ultimately, our numbers sometimes came very close to those from outside sources, and sometimes differed substantially (especially for CMO tranches).
 
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