I was under the impression, that for any callable bond, the Z-spead should not be used. Granted, this includes MBS, becuase they have inherent call options in them. When rates go down, you can refinance, and that causes prepayment…therefore your (if you are the tranche holder) MBS is “called” (simplified). Now in LOS 61.i (fixed income and derivatives) it says that you can use the Z-spead if the MBS is held until maturity. Does the assuption of “held until maturity” mean that there is no pre-payment?? It must, otherwise its mistake, no?? cheers, and thanks in advance
It’s just wrong to the extent that your cash flows are not predictable. That means it’s more wrong for some MBS than others. I guess they mean you can use it for the ones in which it is not too wrong.
thats what i tought… i hate that about the material, it always tries to lead towards confusion…
a lot of people in the industry use it as a “base case” measure, to compare two bonds assuming no vol/rate shifts. then you incorporate “expected” prepayments and go from there. its just a starting point. i wouldnt sell a bond to a client cause it has a wide z-spread, but i might mention if vol drops substantially and rates dont move too much, bond A has a much wider z-spread (aka base case ROR) than bond B