Does OAS exclude default risk? So it has limited applicability to the analysis of speculative grade bonds?
The only thing that OAS removes is the option value. All other risks – interest rate risk, yield curve risk, default risk, downgrade risk, event risk, currency risk, liquidity risk, the whole megillah – are included in OAS.
Answer to Q26 of Reading 21:
A is correct. OAS has limitted use in analysis of speculative grade bonds because default risk is excluded from the calculation.
With all due respect to CFA Institute, that’s a silly way of looking at it.
The price of a speculative grade bond includes the (negative) value of default risk. If you include default risk in the methodology for computing a spread, then you are excluding the value of the default risk: you’re computing a spread for a default-free bond. Perhaps their point is that you should compute the spread for the default-free bond and compare that to other default-free bonds’ spreads. There’s merit in that. But that’s not an indictment against OAS.
If you have a speculative grade bond with embedded options, then you need to compute the spread with both the default risk removed, and the option value removed. Doing either one without the other is pretty much useless.
The binary OAS model in level II was applied to either investment grade bonds, or MBS guarnteed by the government. OAS includes credit risk, but excludes the optionality of default. Thus the pricing of an option-embedded bond will include default risk differently than an option-free bond with the same credit rating due to more than interest rate volatility and prepayment. Any bond with an embedded option can have an OAS calculated for it. Just because we calculate OAS, doesn’t mean that the bond does not have default risk. So we need to be clear whether we are talking about the bond or the OAS. The bond (and it’s price) contains default risk, but the OAS does not include default risk into its calculation.
I’m not a FI guy, at least that’s what I understand so far. For exam purposes, remember to write down that one of the problems with OAS is that it _ excludes _ default risk from it’s calculations, even though it might be true in practice.
What is “the optionality of default”?
Options are one thing; default is quite another.
The answer says OAS excludes credit risk, thus it has limited use in analyze speculative grade bonds.
The answer’s wrong: OAS excludes _ only _ option value.
That’s not to say that OAS helps determine the value of the credit risk: it doesn’t. But saying that it excludes credit risk is stupid.
If it did exclude default risk, it would be very useful: the difference between the z-spread and a spread that excludes default risk tells you the cost of default.
I meant the probability of default, or the issuer’s “option” to default.
There seems to be a bit of confusion about the words “include” and “exclude” here; I blame CFA Institute for this.
When we say that a spread includes a particular risk, we mean that the extra yield required to accept that risk is part of that spread. When we say that a spread _ excludes _ a particular risk, we mean that the extra yield required to accept that risk _ is not _ part of that spread.
The z-spread _ includes _ everything: interest rate risk, yield curve risk, default risk, downgrade risk, event risk, currency risk, liquidity risk, and option costs:
- If there’s a chance that interest rates could increase or decrease, the extra yield that bondholders require to accept that risk is included in the z-spread: it’s higher that it would be if there were no interest rate risk.
- If there’s a chance that the shape of the yield curve could change – steepen, flatten, hump, butterfly, whatever – the extra yield that bondholders require to accept that risk is included in the z-spread: it’s higher that it would be if there were no yield curve risk.
- If there’s a chance that the bond issuer could default, the extra yield that bondholders require to accept that risk is included in the z-spread: it’s higher that it would be if there were no default risk.
- If there’s a chance that the bonds will be illiquid – that a bondholder will have a difficult time selling the bonds quickly at the market price – the extra yield that bondholders require to accept that risk is included in the z-spread: it’s higher that it would be if there were no liquidity risk.
- If the bond has embedded options – call options, put options, prepayment options, conversion options, whatever – the extra yield that bondholders receive (for options favoring the issuer) or pay (for options favoring the bondholder) is included in the z-spread.
- And so on.
The z-spread includes _ everything _. Thus, from the z-spread alone you cannot determine the extra yield for any given risk, or the cost of any given option: they’re all lumped together and all you see is the total.
The OAS removes (_ excludes _) the spread associated with all embedded options, but not the spread associated with anything else.
- For a callable bond, the OAS removes the spread associated with the call option. By comparing the OAS to the z-spread, we can determine the spread attributable to the call option alone.
- For a putable bond, the OAS removes the spread associated with the put option. By comparing the OAS to the z-spread, we can determine the spread attributable to the put option alone.
- And so on.
Because the OAS does not exclude the spread associated with interest rate risk, we still cannot determine what that spread is. Because the OAS does not exclude the spread associated with liquidity risk, we still cannot determine what that spread is.
And because the OAS does not _ exclude _ the spread associated with default risk, we still cannot determine what that spread is.
If we want to know the spread associated with default risk, we need to calculate a spread that _ excludes _ the possibility of default ( and excludes nothing else ); we can then compare that spread to the z-spread (which includes the possibility of default) to calculate the spread associated with default risk.
By the way, I, for one, have never heard of such a spread. Conceptually, it’s easy, but it’s apparently not something that’s computed commonly.
Your post is spot on as always, but again, you might be missing the point.
OAS includes default risk, but excludes defuault risk from its calculation. This is why it’s a sub-optimal method.
As I said above, one of the disadvantages of OAS is that it “excludes default risk from it’s calculations”.
Consider two identical bonds from the same issuer issued at par ($1000), but one bond has a put option at a strike price of $800, Now if the company is suddenly on the brink of defualt, and the option is in the money, you will get two different OAS for both bonds, even though they should be identical.
OAS for relative valuation does not take into account defualt risk for this reason. A better way of saying it, Z-spread does not reflect default risk when comparing speculative bonds with the same credit rating.
LIke you said above, “The z-spread includes _ everything _. Thus, from the z-spread alone you cannot determine the extra yield for any given risk, or the cost of any given option: they’re all lumped together and all you see is the total.”
This is important because OAS was mainly used for investment grade MBS and corps, now that defualt risk is real and priced in, it skews the initial concept.
I do get the point: OAS doesn’t help in valuing the default risk of below-investment-grade bonds. I agree.
I’m taking issue with the explanation: if OAS excluded default risk, it would be useful in valuing such bonds. The reason that it’s not is that it _ includes _ default risk.