Fixed Income OAS

Just a quick question i ran into in the Schweser study notes that kind of confused me. Bond A has an embedded option, a nomial yield spread to Treasuries of 1.6%, a zer0-volatility spread of 1.4%, and an option adjusted spread of 1.2%. Bond B is identical to Bond A except that it does not have the embedded option, has nominal yield spread to Treasuries of 1.4%, a zero volatility spread of 1.3% and an option-adjusted spread of 1.3%. The most likely option embedded in Bond A, and the bond that is the better value, are: embedded option better value a. put bond a b. put bond b bond a bond b I thought it would be c since the for a callable bond the oas will be less than the z-spread and the difference in the two will be the option cost. The book has chosen b. stating that since the oas is less than the z-spread for bond a , the effect of the embedded option is to decrease the required yield, so it must be a put option and not a call option. Anyone have an opinion on this. Thanks

So go through it slowly 1) The bigger the spread the cheaper the bond. A bond trading at a z-spread of 10% is a trashy credit - something at 20 bp is agency debt. 2) Bond A is cheaper without the effects of options (Z-spread) than with the effect of options (OAS). Thus, the benefit of the option accrues to the bondholder. 3) Puts accrue to the bondholder because if interest rates rise, the bondholder can get rid of the thing. Calls accrue to the issuer because if interest rates decrease they can refinance 4) 2 and 3 together => it’s a put

as Joey mentioned and to answer your question, a bondholder is willing to earn a lower yield (i.e. less spread) when there is an option value to the bondholder (i.e. a put). You’re statement above “for a callable bond the oas will be less than the z-spread and the difference in the two will be the option cost” is incorrect… the spread will be MORE for a CALLABLE bond since the bondholder can demand a higher yield for a bond that maybe called away in the future. Don’t confuse the bond-price-to-interest-rate-chart where the bond price is lower for a callable bond with the idea of a tighter spread… in fact that chart should illuminate the fact the a callable bond has a lower price (i.e. higher yield) which illustrates this effect of a call option.

Hey Joey and Charlee, Greatly appreciated for the help. Hopefully one day I will be on the other side of these questions helping the new candidates like myself.

Pay it forward…