_ Which of Avelyn’s comments regarding considerations in the bottom-up approach is most accurate? _
_ Callable debt has a smaller option-adjusted spread than comparable non-callable debt. _
_ Benchmark corporate bond issues normally have wider spreads than older bonds of the same issuer. _
_ The announcement of a new corporate bond issue often leads to an increase in the credit spread on the existingbonds. _
CORRET ANSWER = 3.
As far as i know, also comment 1 is correct. OAS for callable bonds is lower than otherwise identical option-free bond, because of the option value etc. etc… is there a mistake from the book or what??
Hi S2000 - Isn’t this only correct assuming zero-volatility? If there is rate volatility than the OAS on a callable bond will be lower than the OAS on a non-callable bond (which will equal the z-spread. Since OAS = Z-Spread - Option Cost, the only way for the non-callable bond and the callable bond to have the same spread is to have 0 volatility, and thus no option value. Is that why they are the same? I am not sure I understand.
Take for example a bond that gets called due to a fall in interest rates. The OAS of this bond would then be lowered because you are not getting any of the upside from the fall in rates, however a non-callable bond would benefit and thus the spreads added to each node would be different with the Z-Spread > OAS.
The errata says:
Callable debt has a smaller z-spread than comparable non-callable debt
Z-spread is what you add to each point of the spot curve, to discount the cash flows of the bond in order to make them equal its market price.
So, callable debt has a smaller Z spread, because a callable bond has a lower price compared to an option-free bond (because the call option belongs to the issuer, so investors are willing to pay a lower price for a callable bond). For this reason, the Z-spread must also be lower. Is my understanding correct?
A callable bond has a lower price than that of an otherwise identical straight bond.
To get a lower price from the same cash flows, the discount rates have to be higher.
Therefore, a callable bond should have a higherz-spread than an otherwise identical straight bond.
Another way to think about it: for a straight bond you get paid a spread for the bond and nothing else. For a callable bond you get paid that same spread for the (same underlying, option-free) bond, and you paid an additional spread for selling the call option.
Thanks, magician! Correct, if you think abt discounting, the rates must be higher to get a lower price. Therefore, z-spread must be HIGHER. This should be also corrected in the errata!
