I know there are a million threads on OAS and I get that it’s the Option Removed spread and the spread you are getting paid for taking the additional risk over the benchmark treasury. There’s a piece in the application that I’m missing and could use some clarity on.
I’m just pulling these numbers out of my ass so they may not work out but hopefully, the point will get across.
Suppose that hypothetically the 2yr govy is @ 2.30 and you buy a 2yr agency berm at par with 2.40 coupon but the OAS on the callable is negative. Clearly, you are getting a +10 spread to the 2.30, but why would the OAS be negative? What is happening in the background to say that you are essentially giving up something, despite the higher yield, in owning the callable of the treasury?
Again, this example may not work out perfectly as I may not be making the right illustration based on my lack of understanding but I have seen bonds at par or below with higher coupons than benchmark curve and still showing a negative OAS.