If we are looking at two seperate bonds and one has an OAS of 25bps and another has an OAS of 5bps, and we assume the bonds are efficiently priced, then it would be safe to assume the bond with the 25bp OAS has a significantly higher probability of being called.
But that assumes the bonds are efficiently priced. From the question posed above, I would assume its an all else being equal sort of thing, so if it were two different Spreads on the same bond, I’m choosing the bigger one all day.
bmer444 is correct. If you are comparing 2 securities with the same ratings (e.g., AA) and duration, all else equal, the security with the highest OAS is relatively underpriced.
1logic is incorrect when he stated that “the 25bp OAS has a significantly higher probability of being called.” Higher OAS excludes the value of the option, so the spread has nothing to do with the probability of being called. Am I wrong here?
It has noting to do with prepayment speed. If Z spread and Effective duration is constant, Higher OAS (than required OAS) will have lower Option cost, It will be Undervalued and hence will be bought over. That is the correct proposition.
On the other note, I do not agree with that it will be called with lower OAS.
Numerous incorrect assertions in this thread… Option cost = Z-Spread - OAS Higher OAS implies a lower option cost, which on a relative basis is preferable to the investor, who is short the prepayment option.
Went back and looked at some FI and I was wrong. BostonGeorge is right and so is 5XEBITDA. The OAS is the spread above treasuries, so Option Cost = Z-Spread - OAS gives you the value of your option. So in the case of a bond with a call is going to result in a negative option value correct? Where as in the case of a put option Option Cost would be positive.
OAS is option adjusted spread. Which means that the spread (return over benechmark) you are getting after the risk associated with option (cost) is adjusted. Higher OAS means higher return. You’ll like to have a bond which gives you more spread.