Thanks so much for this. I’m on the brink of understanding it. I don’t know why but every time I revisit for the next level it scrambles my head again!
Writing this to try to get it straight in my head conceptually. Please do correct/improve:
What the OAS is doing is essentially trying to strip OUT the impact of the option (volatility) to get a read on the underlying yield of the bond on an apples-to-apples basis vs. similar bonds without embedded options. What it is NOT doing is adding IN the ‘extra’ value that the option represents - this is where my confusion has always been, with the (errant) logic being: “The put option value will increase the bond price. Therefore the yield will be lower. Therefore the OAS must be lower than the Z-spread”.
Wrong - here’s why:
The current market price of bonds includes two components:
- The value corresponding to the underlying bond assuming zero volatility (“spread” here represents compensation for credit risk premium, term premium, etc.)
- The value corresponding to the embedded option on the bond, which varies with volatility (using a put option for example: higher volatility → higher value → put options have value to the investor → higher premium added to the price of the bond (i.e. investor has to pay more for it))
The Z-spread is just a constant number that’s being applied to the periodic cash flows to ‘solve’ for the market price. It is ‘blind’ to the difference between 1 and 2 above. That’s fine if volatility has no impact (i.e. nonputable bond, #2 above = 0) but not when volality is in the mix.
Taking a putable bond:
- The value of the option is positive to the investor (since they can put the bond if rates go up high enough)
- The market price for the putable bond is therefore HIGHER than the nonputable equivalent
- The Z-spread (i.e. the backsolved x-factor) is therefore LOWER than the nonputable equivalent, since a lower discount rate is needed to equate the future cash flows the (higher) present value
- So if you are simply comparing the putable bond vs. a nonputable bond on the basis of Z-spread alone, you may end up making the wrong choice from a non-volatility risk/return perspective.
But really for the apples-to-apples comparison, you need to strip out the value of option and compare only the yields on the underlying bonds themselves.
So for the putable bond above:
- The OAS essentially REMOVES the present value of the option from the market price (adjusting it downwards, because the option value is positive) - note, this is the fundamental reason why my logic in the first para is wrong
- This in turn increases the required spread to equate the future cash flows back to the lower market price*
- This higher spread IS the OAS i.e. I am adjusting the spread the remove the impact of the option so I can compare like-for-like on an option-free basis
In this circumstance, you might find the putable version actually offers a higher underlying yield for the non-volatility risk exposures you are taking on, and therefore choose that instead.
Hope this makes sense?
*Added afterwards: in this instance, am I right in thinking that the future cash flows are also theoretically adjusted downwards to remove the put feature, but given the PV of the put option will be priced at greater than zero by the market, the implied discount rate (OAS) has to go up on a net basis?