OAS

[passcfaforsure]

Dear All:
The wider the OAS , the higher the risk, so why the analyst would like the OAS to be high as the below problem?
Thank you so much for your time.

Generally speaking, an analyst would like the adjusted spread (OAS) to be:
A)
big.
B)
small.
C)
zero.
Your answer: B was incorrect. The correct answer was A) big.
Generally speaking, an analyst would like the OAS to be big.

 

[rockmania]

We are talking about fixed income securtities here. Higher OAS gives me higher cash flow. Where do you see the risk?

 

[1logic]

rockmania wrote:
We are talking about fixed income securtities here. Higher OAS gives me higher cash flow. Where do you see the risk?

If we are looking at two seperate bonds and one has an OAS of 25bps and another has an OAS of 5bps, and we assume the bonds are efficiently priced, then it would be safe to assume the bond with the 25bp OAS has a significantly higher probability of being called.
But that assumes the bonds are efficiently priced. From the question posed above, I would assume its an all else being equal sort of thing, so if it were two different Spreads on the same bond, I’m choosing the bigger one all day.

 

[bmer4444]

I believe the answer is that you’re looking at comparable securities when comparing spreads, so all else equal the higher the spread the more undervalued the security.
The OAS removes any value connected to the option, so bonds with options can be compared to bonds without options or different options.

 

[5X EBITDA]

bmer444 is correct. If you are comparing 2 securities with the same ratings (e.g., AA) and duration, all else equal, the security with the highest OAS is relatively underpriced.
1logic is incorrect when he stated that “the 25bp OAS has a significantly higher probability of being called.” Higher OAS excludes the value of the option, so the spread has nothing to do with the probability of being called. Am I wrong here?

 

[krishna11]

It has noting to do with prepayment speed. If Z spread and Effective duration is constant, Higher OAS (than required OAS) will have lower Option cost, It will be Undervalued and hence will be bought over. That is the correct proposition.
On the other note, I do not agree with that it will be called with lower OAS.

 

[1logic]

5X EBITDA wrote:
bmer444 is correct. If you are comparing 2 securities with the same ratings (e.g., AA) and duration, all else equal, the security with the highest OAS is relatively underpriced.
1logic is incorrect when he stated that “the 25bp OAS has a significantly higher probability of being called.” Higher OAS excludes the value of the option, so the spread has nothing to do with the probability of being called. Am I wrong here?

I believe that OAS = Value of Option Bond - Value of Bond w/o option. So OAS is the value of the option.

 

[BostonGeorge]

Numerous incorrect assertions in this thread….
Option cost = Z-Spread - OAS
Higher OAS implies a lower option cost, which on a relative basis is preferable to the investor, who is short the prepayment option.

 

[1logic]

Went back and looked at some FI and I was wrong. BostonGeorge is right and so is 5XEBITDA. The OAS is the spread above treasuries, so Option Cost = Z-Spread - OAS gives you the value of your option. So in the case of a bond with a call is going to result in a negative option value correct? Where as in the case of a put option Option Cost would be positive.

 

[mohammad.belaal]

OAS is option adjusted spread. Which means that the spread (return over benechmark) you are getting after the risk associated with option (cost) is adjusted. Higher OAS means higher return. You’ll like to have a bond which gives you more spread.
OAS = ZVS - Option Cost
or Option Cost = ZVS - OAS
This is the correct notation.

 

[BostonGeorge]

mohammad.belaal wrote:
OAS is option adjusted spread. Which means that the spread (return over benechmark) you are getting after the risk associated with option (cost) is adjusted. Higher OAS means higher return. You’ll like to have a bond which gives you more spread.
OAS = ZVS - Option Cost
or Option Cost = ZVS - OAS
This is the correct notation.

Good post. Although it should be obvious, I would add one caveat. An investor would prefer a bond with more spread for a given level of risk.