The text says that OAS is useless in analyzing speculative-grade bonds “because default risk is excluded from the calculation”. (Reading 29 eoc question #26.) This doesnt make sense to me. Isnt oas basically the credit-risk spread of a bond, calculated by removing the portion of the actual spread that is due to the built-in option? That is, I thought the whole point of oas was to calculate the spread as if the bond didn`t have an option. Since high yield corporate bonds are the most likely to be callable, OAS seems very relevant to me in assessing their default risk. Is my understanding of oas incorrect?
yeah–their comment doesnt make sense…is there something else you are missing? dont have cfa books with me at the office. oas doesnt remove default risk
yeah I came accross this last night in CFA EOC and got it wrong. I went to the section and re-read and it made no sense to me. glad I wasn’t the only one.
Ok, then ill assume im not missing anything important. Thanks.
Makes no sense… And it isn’t in CFAI Errata… Found a good definition… Option-Adjusted Spread (OAS) Definition Option-adjusted spread (OAS) is the spread relative to a risk-free interest rate, usually measured in basis points (bp), that equates the theoretical present value of a series of uncertain cash flows of an instrument to its current market price. OAS can be viewed as the compensation an investor receives for assuming a variety of risks (e.g. liquidity premium, default risk, model risk), net of the cost of any embedded options.
I think what they are getting at is that speculative grade debt, where there is a reasonable likelihood of default, trades on a dollar price basis, not a spread basis. In this case, OAS is not an applicable method of analyzing the relative value of the bond. For example, when default is likely it is not uncommon to see 5yr and 10yr bonds (of the same credit) trading at the same dollar price with very different yields. This is because investors are betting on recovery payouts that are usually equal for all bonds holders regardless of maturity.