It is mentioned in the Kaplan note that Putable Bond has a larger OAS then an option-free bond since it captures the potatentially favourable impact of the put feature on the investor’s return. I understand that holding a put option is obviously more valuable to the investor. However, it seems counterintuitive to me that with a larger spread meaning the price is cheaper, so it’s cheaper to buy a putable bond than an option free bond? Shouldn’t it get more expensive to reflect the value of the put option? that means investors need to pay more to buy the bond embedded with a put option, and they should take a lower yield reflecting it’s less risky to them? since put option essentialy put a price floor on the bond…
Thanks but could you elaborate a bit more? that seems a bit contradicting…
you’re saying OAS of a putable bond should be the same as the OAS of an otherwise option-free bond, and for an option-free bond, Z-spread would be the same as OAS. if you’re right then, that means OAS of a putable bond would be the same as Z-spread of an option free bond. that would contradict the materials and examples provided in the Kaplan note…
The point of the OAS is to remove the value of any embedded options so that you have a spread that is comparable across all bonds. If you remove the value of the put option, you’re left with an option-free bond, so the OAS is the OAS of the option-free bond.
Yes, yes, and yes.
Assuming, as I wrote initially, the bonds are fairly priced.
The goal is to get a idea of the credit risk that each bond faces. The amount of credit risk is typically represented by looking at the additional yield of a risky bond compared to a credit-risk free bond.
A put option is valuable to an investor, which will increase the price and decrease the yield. Without correction, it will look like this bond has a lower credit risk. However, the put option doesn’t change anything about the credit risk. The OAS is the spread that actually represents the credit risk. By removing the put, the spread will increase, so for a putable bond the OAS will be larger than the apparent z-spread.
I think I found the example in Kaplan that you are referring to and I agree that it is poorly explained. I believe @S2000magician’s key point is that the OAS should be the same between the different types of bonds if the bonds are priced fairly. Looking at the example, the bonds do not appear to be priced fairly as the putable bond is cheaper than the option-free bond. As a result, the OAS is higher, as the cash flows of the bond need to be discounted more to arrive at the lower price.
If priced fairly and all else equal, the OAS of a callable, putable, and option-free bond should be the same as you should earn the same risk-adjusted return on each of the bonds. Assuming they pay the same coupon rate, the callable bond will have the lowest price because its projected future cash flows are lowest (because it may be called back if rates decrease), and the putable bond will have the highest price because its projected future cash flows are highest (because you can put it back to the issuer if rates increase).
Alternatively, if the bonds all have the same price, and are still priced fairly (they have the same OAS), this means the callable bond has the highest coupon rate and the putable bond has the lowest coupon rate.