Relative OAS valuation

[sgupta0827]

Hi Folks,
I am having hard time understanding relative OAS valuation concept from study session 14 and reading 50. I am not sure about what exactly is required OAS and what is actual OAS,and why the bond is overvalued in case of treasury benchmark if OAS>0? It will be very helpful if someone could summarize their understanding of this topic.

 

[Kiakaha]

Think of OAS as the extra compensation investors get, over a benchmark, in return for holding a bond.
Required OAS is what investors require, based on their assessment of how risky a company is. (the more risk, the higher the required OAS.)
Actual OAS is the OAS calculated based on where the bonds are actually trading.
So if the actual OAS is higher than your required OAS, you would buy the bond because you’re being given more compensation than what you think is the minimum needed.
If the required OAS is higher than the actual, you wouldn’t buy the bond because it’s not offering you the return you think you need, in order to take on the risk.
With treasuries as your benchmark, if the OAS is LESS than zero (you have it round the wrong way above), you’re being paid less than what you’d get by holding treasuries. (ie instead of getting a spread above a benchmark, you are getting less than the benchmark.)
seeing as all bonds have more credit risk than treasuries, the logic is that the other bond must be overvalued. (because there’s no way it should be ‘worth more’ than treasuries.)

 

[sgupta0827]

Hi Kiakaha,
As usual you seem to have good grasp of the topic, and you have provided very good explanation for required vs actual. But I am still struggling with where does “less than zero” reference come in the picture when the spread of a bond is being compared with spread of treasuries or some other bond.
As far as I understand one curve is being compared with another curve. Are these scenarios for the curves in different qudrants such as first quedrant or fourth quadrant? Is that the reason we are talking about OAS being less than zero, greater than 0 or equal to zero? From your explanation, it looks like rather than talking relatively about spreads such as greater than or less than the benchmark itself, we are evaluating the equation (target bond-benchmark). If target bond spread> benchmark, OAS>0.
By the way, in scheweser, there are so many different scenarios for this and I don’t think I messed it up:
I will try to put all of them here:
Treasury benchmark
if OAS>0: Overvalued if actual OAS<required OAS; undervalued if actual OAS>required OAS
OAS=0: Overvalued
OAS<0 Overvalued
sector benchmark
if OAS>0: Overvalued if actual OAS<required OAS; undervalued if actual OAS>required OAS
OAS=0: Overvalued
OAS<0 Overvalued
Issuer specific benchmark
if OAS>0: Undervalued
OAS=0: Fairly Priced
OAS<0: Overvalued
Thank you so mcuh once again for your response.

 

[sgupta0827]

Glad to see that there were other people on the forum who had hit the mental block on the exact same topic. Just browsed some threads on the forum on relative valuation, and now it now makes perfect sense. I didn’t get it in first time, because I was visualizing curves for the spreads, but I missed that there could be absolute values for the spreads as well. Thanks!