Roadblock on Relative OAS Valuation

For whatever reason I’m hitting a mental road block on this one. I’m going through the schweser notes. Page 73 Figure #3 book 5. For relative OAS Valuation against the Treasury Bench Mark-- If OAS> 0 it is overvalued. (If Actual OAS is > required it is undervalued) If OAS=0 it is overvalued If OAS < 0 overvalued. It’s just not making logical sense to me. I understand that the Z spread is the spread of an issue compared to benchmark minus the option cost to come up with the OAS. When is a bond undervalued vs. the Treasury Benchmark? An example? Any insights on how to get past this?

Think about it this way. If everything was priced perfectly and your required OAS is 100 than the actual OAS should be 100. But what if it was 200? That would mean that you are getting compensated with 200 basis points when you actual only require a 100 basis point compensation. Basically you are getting paid more than is required for the level of risk you are taking. Therefore the bond is undervalued (you are getting paid more than you should).

GMofDen, Now looking at your question I think I misunderstood it.

I don’t know if my question was really clear. I’ve used the seach function and looked at other OAS threads but it’s not making complete sense to me obviously. How about this one. If OAS = 0 vs. the Treasury benchmark. How would it be overvalued/rich?

Ok. Remember that the OAS is a spread that reflects compenstaion for Credit risk and liquidity risk. (option risk has been removed). Now if you are comparing a bond to treasuries as your benchmark and the OAS is 0 then you aren’t getting any compensation for credit or liquidity risk. This is because you know the bond you are compaing has more credit and liquidity risk than a treasury (which in theory has no credit risk and little liquitdity). So the bond has to be overvalued. You aren’t getting paid (no extra spread) for the extra risk in your bond.

^ Precisely!! You would not buy an embedded option bond with OAS = 0 when you are comparing it to Treasury benchmarks. Since to come up with OAS, we have already adjusted for the option volatility spread and the only other 2 things remain are credit risk and liquidity risk. So a OAS = 0 means you get no compensation for holding a risky embedded option bond as compared to holding a safe cushioned T-bond. In that sense it’s ‘Overvalued’

Sweeetttt. Thanks mwvt. For whatever reason I was missing that. See if you agree with this one. In comparing Yields vs. benchmarks. Nominal Spreads and Z Spreads don’t properly reflect the risk in any comparisons with embedded options. To properly value an OAS must be used, and if the spread is greater than comparables then you are being compensated more for the amount of risk that you are taking on. One more question. When comparing vs. an issuer-specific benchmark. Why is OAS>0 cheap and why is OAS=0 fairly priced?

GMofDen Wrote: ------------------------------------------------------- >> One more question. When comparing vs. an > issuer-specific benchmark. Why is OAS>0 cheap and > why is OAS=0 fairly priced? The issuer- specific benchmark should have the same credit and liquidity risks as the bond you are comparing (apples to apples) unlike the treasury benchmark. So if you are getting more yeild than your benchmark the security is undervalued.

GMofDen, If you are using Issuer Specific Benchmark then all you need to worry about is the Liquidity risk (no option risk as it’s an OAS (option adjusted) and no credit risk (since it’s the same counterparty)). Liquidity risk is assumed to be very minimal, if at all it’s not zero. So if in that case, you figure out that the OAS = 100 (i.e. OAS > 0) we could say that, just for taking on a ‘little’ liquidity risk, we are getting compensation over and above by 100 bp’s, which is a good deal - hence Undervalued. And on the similar lines, OAS = 0 means the embedded-bond is a carbon copy as far as the risk factors are concerned (same option risk, same credit risk and same liquidity risk) as compared to a benchmark. hence ‘Fairly priced’

GMofDen Wrote: ------------------------------------------------------- > See if you agree with this one. > > In comparing Yields vs. benchmarks. > Nominal Spreads and Z Spreads don’t properly > reflect the risk in any comparisons with embedded > options. > To properly value an OAS must be used, and if the > spread is greater than comparables then you are > being compensated more for the amount of risk that > you are taking on. > I don’t exactly understand the last sentance you are using there, but I think you have it.

You guys rock! Makes perfect sense now. That’s all it took. For whatever reason my brain just wasn’t processing that. That was a big help and saved me a ton of time and frustration. Thanks!

Rule of thumb: Recognize the risks you are taking (either credit, liquidity, defalut or a combination) Evaluate the how much you should be compensated for those risks (required return) Calculate your actual OAS and then compare to your required to determine over/undervalued.

Glad to help.