Key Takeaways
- Adjusts yield spread for embedded bond options.
- Isolates credit and liquidity risk from option risk.
- Essential for valuing mortgage-backed and callable bonds.
- Uses simulations to match bond price with cash flows.
What is Option-Adjusted Spread (OAS)?
The Option-Adjusted Spread (OAS) measures the yield spread added to a benchmark yield curve, typically the par yield curve, to discount a bond's expected cash flows after adjusting for embedded options like prepayment or call rights. This adjustment isolates credit and liquidity risk from option risk, helping you assess the true value of complex securities such as mortgage-backed securities (MBS) or callable bonds.
OAS is expressed in basis points (bp) and is a key tool for investors seeking a more accurate relative value comparison among bonds with embedded options.
Key Characteristics
OAS has several defining features that make it essential for fixed income analysis:
- Option Adjustment: Removes the value of embedded options to reflect only credit and liquidity risk.
- Benchmark Curve: Uses a risk-free curve, often based on U.S. Treasuries or the par yield curve, as the discounting baseline.
- Probabilistic Modeling: Employs techniques like Monte Carlo simulations to capture interest rate volatility and prepayment scenarios.
- Expressed in Basis Points: The spread is quoted as an annualized number, simplifying comparison across securities.
- Applicable Securities: Commonly used for MBS, agency bonds such as AGNC, and other option-embedded debt instruments.
How It Works
OAS is calculated by simulating multiple interest rate paths and prepayment behaviors to estimate expected cash flows under varying conditions. The spread added to the benchmark curve is iteratively adjusted until the discounted value matches the bond’s current market price.
This process accounts for embedded options that can alter cash flow timing, such as prepayment risk in MBS or call features in bonds. By isolating option costs, OAS gives you a clearer sense of the bond’s true yield premium relative to risk-free rates and credit quality.
Examples and Use Cases
Understanding OAS can enhance your bond portfolio analysis and investment decisions.
- Mortgage-Backed Securities: Investors compare OAS across pools to identify those with better compensation for prepayment risk.
- Agency Bonds: AGNC bonds often use OAS to evaluate value beyond the embedded call options.
- Bond ETFs: When selecting bond ETFs, OAS helps compare underlying holdings' risk-adjusted yields.
- Callable Bonds: OAS accounts for issuer call rights, offering a more precise yield measure than nominal spreads or yield-to-call.
Important Considerations
While OAS provides insightful risk-adjusted yield information, it depends heavily on model assumptions about interest rate volatility and prepayment behavior. You should be aware that inaccuracies in these assumptions can distort OAS outcomes.
Also, OAS is less meaningful for bonds without embedded options, where simpler spreads like Z-spread or nominal spread may suffice. Incorporating OAS into your analysis alongside other metrics such as Macaulay duration can improve your fixed income risk assessment.
Final Words
Option-Adjusted Spread (OAS) offers a refined measure of yield that accounts for embedded options, isolating credit and liquidity risk more accurately than traditional spreads. To apply this insight, compare OAS values across similar securities to identify mispriced opportunities or evaluate risk-adjusted returns.
Frequently Asked Questions
Option-Adjusted Spread (OAS) is the constant yield spread added to a benchmark yield curve to discount a security's projected cash flows, accounting for embedded options like prepayment or call rights. It isolates the bond's credit and liquidity risk from option risk and is expressed in basis points.
OAS differs from the Z-spread by adjusting for the value of embedded options within a bond. While Z-spread assumes fixed cash flows and ignores option risk, OAS subtracts the option cost to provide a cleaner measure of credit and liquidity risk.
OAS is vital for valuing MBS because these securities have embedded prepayment options that affect cash flows. By modeling various interest rate and prepayment scenarios, OAS helps investors understand the true yield spread after accounting for these options.
OAS is calculated using probabilistic models like Monte Carlo simulations to generate multiple interest rate and prepayment paths. A constant spread is then iteratively solved so that the average discounted cash flows across scenarios match the security's market price.
OAS mainly accounts for borrower prepayment options, such as refinancing in mortgage-backed securities, and issuer call rights in callable bonds. These options impact cash flow timing and risk, which OAS adjusts for in its valuation.
OAS removes the distortions caused by embedded options, allowing investors to compare the credit and liquidity risk of callable and non-callable bonds on a more equal footing. This makes it easier to identify which bonds offer better risk-adjusted returns.
A higher OAS generally indicates better compensation for credit and liquidity risk after adjusting for option costs. Investors often view bonds with higher OAS as more attractive because they offer a higher yield premium not driven solely by embedded options.
