Dear All:

Bond is undervalued if OAS> required OAS. I really don’t understand about this concepts. highly appreciate if you guys could give some explaination

Thank you so much for your time.

You’re essentially receiving a return that is greater than what is required to compensate you for the related risks. No different than expected return vs required returns for stocks.

If you were to value the bond using the required (lower) OAS, the bond value would be higher than if you used the (higher) actual OAS. The bond seems cheap/undervalued in this case bc it’s price is higher than the market. Therefore, you would have to increase the required OAS for the incremental return (thus increasing the discount rate) in order to get the bond values to equal one another. This results in an OAS that is > required OAS.

Anyone else chime in if i’m wrong or you have a better way to thing about it.

This is true for a bond with a call option, because you’re selling the issuer of the bond an option. Lets assume a company issues two bonds, Bond A and Bond B, they are identical except Bond B is callable after 3 years. So since Bond B is callable after three years I wouldn’t want to pay the same price for it as Bond A, I would pay less because the call option could aversely affect me in the future. So the difference in yield (Yeild B - Yeild A) is the OAS, basically the adjustment of yeild to account for the option.

Then lets say I’m valuing Bond B and I find the fair price of the option to be an additional 15bps(OAS) on top of Yeild A, but right now in the market the OAS is an additional 20bps. So the actual OAS > Required OAS and the bond is cheap, because I’m recieving more yeild/payment for selling the option than I require.

I don’t think the different OAS will change the discount rate, because in both cases you’re just using the spot rates derived from your binomial interest rate model to discount the cash flows.

BMiller’s analysis is solid!

First spread is the excess amount after adjusting risks including associated with option. Higher spread means higher return. It means that what we are expecting from a bond to pay us, it is paying us more than that (OAS > Required OAS) which implies that the price at which the bond is selling (PV) is lower as compared to what we think or require (FV/ 1+Required rate of return). Therefore the bond is undervalued because based on our required OAS it should have value higher than what it actually is trading at. The opposite applies for bond with OAS < Required OAS.