“If the OAS for a bond is higher than OAS of its peers, it is considered to be undervalued and hence an attractive investment (i.e., it offers a higher compensation for a given level of risk). Conversely, bonds with low OAS (relative to peers) are considered to be overvalued.” I can’t seem to make sense of why this is the case, is anyone able to explain this concept to me? Thank you!
Think about it - do you want more yield spread or less…
If you have 2 bonds and they are both identical in every aspect would you want the bond that offers you a 200 bps OAS or a 100 bps OAS? Meaning would you want to earn a 2% spread or a 1% spread - Ill take the 2%.
Keep in mind the inverse relationship between price and yield as well. In the above example the bond with the 100 bps OAS (lower OAS) may be trading at say 105 (a higher price) where as the bond with the 200 bps OAS (higher OAS) may be trading at 102 (a lower price). Remember - higher yields and spreads equals lower price. Therefore 105 is too much to pay for this bond because it is overvalued at that price and 102 is too little to pay for this bond because it is undervalued at that price. It should be somewhere in between trading at say 103.50 (150 bps OAS) - again in which case you would want to buy it for 102 (buying at the 200 bps OAS). Remember buy low and sell high!