I have some doubts concerning Q26/p.89 Reading 24. Why doesn’t OAS account for default risk? I remember from Levell II books that OAS accounts for liquidity risk and credit risk (which includes default risk). Could pls somebody help?

Thank you.

The author is stressing on the fact that comparing corporate bonds and junk bonds on the basis of OAS is not appropriate due to the fact that junk bonds OAS include substantial default risk or credit risk in them. And if you factor that in by taking some return off of junk bonds as a compensation for additional credit risk, the resulting spread may not be better than the spreads on other corporate bonds.

Option evaluation models do not consider default risk. So, the resulting OAS after removing just the option value is not a good measure of spread for comparison in higher-risk markets. Junk bonds have high credit/default risk hiding inside OAS. In summary, OAS is not a good spread measure for bonds with high credit/default risk.

The text is not stating that the OAS excludes default risk. Rather, it’s saying that the OAS does not consider the effect that a default would have on the value of the option layer. Therefore, because the option value is unreliable where default risk is elevated, the OAS itself is not a good valuation measure.

Thank you. Now it is clear the OAS is not a good valuation measure for high yield bonds. However, the first sentence in your last paragraph is in contrast to the text. Please look at the correct answer (A) for Q26. It sates specifically that ‘OAS excludes deafault risk from its calculation’…

it states that - accepted - but interpretation which makes things clearer is “OAS excludes the possibility of default”, or as has been stated above - it does not consider the effect default would have on the value of the option layer".

If you had two bonds -

one callable bond from a highly credited issuer, with no default possibility

and another from a “high yield junk issuer” who has a high possibility of default

and both bonds had the same OAS - which one would you prefer?

well, obviously the first one.

Still … I think the wording is quite unfortunate.

Thanks for the discussion.