still don’t understand what the difference they have… Thanks
Are you posting in the wrong forum? FYI, this is Lv2 box.
what is normal spread? nominal?
Nominal spread = difference between yield on the security and yield on the benchmark. Z-spread = the amount added to the benchmark spot rate curve in order for the calculated price to equal its market price. It assumes a constant term structure of interest rates.
Check on my understanding… so, if I have a bond with known cash flows for 3 years, how do I know how much it is worth today? Of course, there is a market price for the bond, but I still want to know what the “real” price should be. One way is to discount the cash flows using known interest rates like those found on the treasury yield curve. That should work, but the price I get using those rates (assuming the bond is a corporate bond) will be too high. Why? Because I’m discounting using relatively low treasury interest rates. So, I cannot trust the price I get. Nominal spread If I start adding a little bit to those treasury interest rates, I can find another price for the bond, which is a little lower than previously. Once I find a price which is equal to the market price, the additional amount I put on top of the treasury rates, would be the nominal spread. So, I can say that this bond is priced by the market at 1.2% (100 bps) above the treasury. If another bond is priced at 1.3%, I prefer the larger spread one. Z-spread What if I use the treasury spot rates to discount the cash flows of this given bond? I should get yet another price for the bond, right? Every time you use different rates you get a different price. That price would be identical the one I calculated earlier using the treasury rates, because spot rates and YTM rates give same price. But, if I add a little on top of those spot rates until I get a price equal to the market’s price of the bond, that additional amount would be the z-spread. So, I can say that this bond is priced in the market at a Z-spread of x bps (relative to benchmark spot rates, treasuries in this case). Now I can compare different bonds using same standard…this bond’s Z-spread is 1.2%, while another bond has 1.3% Z-spread. Which one is better? For now, the 1.3% is better. OAS The above method ignored the fact that some bonds are callable, some putable, some have variable coupons, etc. That means the cash flows I assumed to be known before, are not necessarily so. Therefore, I have to value my bond assuming that coupons change or that the bond may be called at $102 (even if it was trading at $104), etc. If you plug in some rates that would make the model’s bond value equal to the price in the market, with all the correct cash flows, you have just calculated an option-adjusted spread. This is the best rate I can use to price my bond. If another bond is trading at an OAS of 20 bps, and mine is at 25 bps, mine is better. I wrote this in a little bit of a hurry, so please stop me if I wrote something incorrect.
Dreary, well done, good explanation, the higher the spread, the better for the investor.
Let us say that you find that using the treasury spot rates, that your bond has an OAS=0. Is your bond cheap, expensive, or fairly priced? This means that your bond offers the same rate as treasury bonds, so why buy it and get same return as the more secure government bonds. It’s expensive. What if its OAS < 0? It means its offering a return (a yield) lower than the treasuries…that’s even worse. Too expensive. only if its OAS > 0, would it make sense to even consider buying it, and even then you’d have to compare its OAS to other similar bonds. Let us say, you then suggest to use the issuer’s own yield curve to judge the value of this bond. You then find that its OAS=0. Is your bond cheap, expensive, or fairly priced? Well, its offering same rate as other bonds of the issuer, so it’s just as good as identical bonds…it’s fairly priced. If its OAS > 0, you are getting a higher yield with this bond, than identical bonds…hey that’s great, it’s cheap. What if you say I want to compare it to bonds in the same sector, with better rating, and find that its OAS=0, is your bond cheap, expensive, or fairly priced? You are getting same yield as better bonds so buy the better bonds…it’s too expensive. What if its OAS < 0? It’s giving you a yield lower than better bonds, so buy the better bonds…also too expensive. Only if its OAS > 0, that you would then see if it’s yielding enough to cause you to buy it (you would need to know what the minimum required yield, or required OAS to judge.). Hope that helps some of you.