Adjusted benchmark spread

What Is Adjusted Benchmark Spread?

Adjusted benchmark spread, often referred to as an "option-adjusted spread" (OAS), is a financial metric used primarily in fixed income analysis within the broader category of portfolio theory. It quantifies the yield difference between a callable bond or other complex fixed-income security and a comparable benchmark U.S. Treasury security, after accounting for the value of embedded options. This adjustment makes the spread a more accurate measure of the compensation an investor receives for taking on non-interest rate risks, such as credit risk, liquidity risk, and prepayment risk. The adjusted benchmark spread allows for a more "apples-to-apples" comparison between bonds with different structural features, providing insight into the true risk premium.

History and Origin

The concept of bond spreads, in general, has long been a fundamental part of bond market analysis. Investors traditionally compare the yield of a corporate bond to a "risk-free" U.S. Treasury bond of similar maturity to gauge the additional compensation for credit risk¹⁴. However, as financial markets evolved and more complex fixed-income instruments with embedded options, such as callable bonds or mortgage-backed securities, became prevalent, the simple yield spread proved inadequate. These embedded options, which give either the issuer or the investor certain rights (e.g., the right for an issuer to buy back a bond before maturity), significantly impact a bond's effective yield and price sensitivity.

The development of sophisticated option pricing models in the late 20th century, particularly the Black-Scholes model and its extensions, paved the way for the creation of the option-adjusted spread. These models allowed for the quantification of the value of these embedded options. By stripping out the value attributable to these options, analysts could determine a spread that reflected only the non-option risks. The Federal Reserve, among other institutions, tracks various option-adjusted spreads for different corporate bond indexes, providing historical data for analysis¹³,¹².

Key Takeaways

• The adjusted benchmark spread (Option-Adjusted Spread or OAS) isolates the non-interest rate risks in fixed-income securities with embedded options.
• It measures the compensation investors receive for taking on credit, liquidity, and prepayment risks, among others.
• OAS is expressed in basis points and is calculated by simulating various interest rate paths and valuing the bond at each path.
• A higher adjusted benchmark spread generally indicates greater perceived risk or higher compensation for that risk.
• It is a crucial metric for comparing complex fixed-income securities and understanding their true risk premium.

Formula and Calculation

The calculation of the adjusted benchmark spread is complex and typically involves an iterative process using a binomial tree or Monte Carlo simulation to model potential future interest rate paths. The general idea is to find the constant spread that, when added to the benchmark yield curve, makes the theoretical value of the bond (including its embedded options) equal to its current market price.

The formula can be conceptualized as solving for OAS in the following equation:

Where:

• ( P ) = Current market price of the bond
• ( C_t ) = Cash flow at time ( t )
• ( r_t ) = Benchmark risk-free rate (e.g., Treasury yield) at time ( t ) for a given interest rate path
• ( OAS ) = Option-Adjusted Spread (the variable being solved for)
• ( N ) = Number of cash flows

This calculation effectively removes the impact of volatility in interest rates and the value of embedded options, allowing for a clearer assessment of the other risks inherent in the bond.

Interpreting the Adjusted Benchmark Spread

Interpreting the adjusted benchmark spread involves understanding that it represents the yield premium over a risk-free rate that compensates investors for non-interest rate risks. A higher adjusted benchmark spread implies that the market demands greater compensation for the bond's credit quality, illiquidity, or other unique features. For example, bonds with lower credit ratings or those in less liquid markets tend to exhibit wider adjusted benchmark spreads¹¹,¹⁰.

Conversely, a narrowing adjusted benchmark spread suggests that investors perceive less risk or are willing to accept lower compensation for the existing risks. This can occur during periods of strong economic growth or increased market confidence⁹. When analyzing the adjusted benchmark spread, it's important to compare it to historical levels for the same bond or similar bonds, as well as to the spreads of other asset classes. A widening spread might signal deteriorating credit quality or liquidity concerns, while a tightening spread might indicate improving fundamentals or increased demand for the security.

Hypothetical Example

Consider two hypothetical bonds, Bond A and Bond B, both with a face value of $1,000, a coupon rate of 5%, and five years to maturity. Bond A is a plain vanilla corporate bond, while Bond B is an identical corporate bond but with an embedded call option, allowing the issuer to redeem it early.

Assume the current 5-year U.S. Treasury yield (the benchmark) is 3%.

If Bond A is trading at a yield of 4.5%, its simple spread over the Treasury is 1.5% or 150 basis points.

For Bond B, due to its call feature, its yield might be higher to compensate investors for the risk of early redemption, perhaps 5%. A simple spread calculation would show 200 basis points. However, this doesn't isolate the credit or liquidity risk.

To calculate the adjusted benchmark spread for Bond B, a financial model would simulate thousands of possible interest rate scenarios. In some scenarios, if interest rates fall significantly, the issuer might call the bond. The model accounts for this early redemption possibility. After accounting for the value of this embedded call option, the adjusted benchmark spread for Bond B might also come out to 150 basis points.

In this scenario, despite a higher simple yield spread, the adjusted benchmark spread reveals that both Bond A and Bond B offer the same compensation for their underlying credit and liquidity risk. The additional 50 basis points in the simple yield of Bond B are solely attributable to the investor bearing the reinvestment risk associated with the call option.

Practical Applications

The adjusted benchmark spread is a vital tool for various participants in the financial markets, particularly in fixed-income investing.

• Portfolio Management: Portfolio managers use the adjusted benchmark spread to compare the relative value of different fixed-income securities, especially those with complex features. It helps them identify undervalued or overvalued bonds, enabling better asset allocation decisions.
• Risk Management: It is crucial for assessing and managing the various risks embedded in a fixed-income portfolio. By isolating the spread attributable to credit and liquidity risks, analysts can better understand the true risk exposures.
• Valuation: The adjusted benchmark spread is a key input in valuing complex bonds. It helps to determine a "fair" yield given the bond's characteristics and the prevailing market conditions.
• Trading: Traders use changes in the adjusted benchmark spread to inform their buying and selling decisions. A widening spread may signal a potential selling opportunity (or a buying opportunity if the widening is unjustified), while a tightening spread could indicate the opposite.
• Regulatory Compliance and Disclosure: Regulatory bodies like the Securities and Exchange Commission (SEC) have emphasized transparency in fixed income markets. Disclosures related to mark-ups and mark-downs, which indirectly relate to spreads, are required for certain transactions to provide more information to retail customers⁸,⁷,⁶.

Limitations and Criticisms

Despite its utility, the adjusted benchmark spread has certain limitations and criticisms:

• Model Dependence: The calculation of the adjusted benchmark spread is highly dependent on the underlying financial models used, particularly the interest rate model and the option pricing model. Different models can produce different OAS values for the same bond, leading to inconsistencies. The accuracy of the OAS is directly tied to the assumptions made within these models, such as interest rate volatility and the correlation between interest rates and other market factors.
• Assumptions about Interest Rate Paths: The simulation of interest rate paths relies on assumptions about future interest rate movements, which are inherently uncertain. If these assumptions deviate significantly from actual market behavior, the calculated adjusted benchmark spread may not accurately reflect the true risk.
• Complexity: The calculation is mathematically intensive and requires specialized software and expertise, making it less accessible for individual investors or those without advanced analytical tools.
• Data Quality: The accuracy of the adjusted benchmark spread also depends on the quality and availability of market data, including accurate bond prices, coupon rates, and relevant benchmark yields. In illiquid markets, obtaining reliable data can be challenging.
• Does Not Isolate All Risks: While it adjusts for embedded options, the adjusted benchmark spread still aggregates various non-interest rate risks (e.g., credit, liquidity, prepayment). It does not separately quantify each of these individual risks, which could be important for a more granular risk assessment. Some research suggests that credit risk accounts for only a portion of observed yield spreads, especially for investment-grade bonds⁵,⁴.

Adjusted Benchmark Spread vs. Credit Spread

The terms adjusted benchmark spread and credit spread are related but distinct concepts in fixed-income analysis. Understanding their differences is crucial for accurate bond valuation and risk assessment.

While a credit spread provides a straightforward measure of default risk, the adjusted benchmark spread offers a more refined view for complex instruments by removing the distorting effect of embedded options. For example, a callable corporate bond might have a higher nominal yield than a non-callable bond from the same issuer due to the call option. The adjusted benchmark spread aims to show if, after accounting for the call option's value, the investor is being compensated similarly for the underlying credit risk.

FAQs

What is the primary benefit of using an adjusted benchmark spread?

The primary benefit of using an adjusted benchmark spread is its ability to isolate the premium an investor receives for bearing non-interest rate risks, such as default risk and liquidity, by accounting for the value of any embedded options within a bond. This allows for a more accurate comparison of complex securities.

How does the adjusted benchmark spread differ from a simple yield spread?

A simple yield spread is the difference between a bond's yield to maturity and a benchmark Treasury yield. It does not account for the impact of embedded options. The adjusted benchmark spread, however, explicitly removes the influence of these options, providing a cleaner measure of the non-interest rate risk premium.

What factors can cause an adjusted benchmark spread to widen or narrow?

Factors that can cause an adjusted benchmark spread to widen include deteriorating credit quality of the issuer, reduced market liquidity for the bond, or an increase in perceived prepayment risk (for mortgage-backed securities). Conversely, an improvement in credit quality, enhanced liquidity, or decreased prepayment risk can cause the spread to narrow. Economic conditions also play a significant role, with spreads often widening during economic downturns and tightening during expansions²,¹.

Is adjusted benchmark spread only relevant for callable bonds?

While adjusted benchmark spread is very relevant for callable bonds, its application extends to other fixed-income securities with embedded options, such as puttable bonds, mortgage-backed securities (MBS), and asset-backed securities (ABS). In these cases, the adjusted benchmark spread helps to account for the option-like features that affect their cash flows and pricing.

Can individual investors calculate adjusted benchmark spread?

Calculating an accurate adjusted benchmark spread typically requires sophisticated financial modeling software and expertise. Therefore, it is generally not feasible for individual investors to calculate it themselves. However, adjusted benchmark spread data for various bond indices and individual securities are often available from financial data providers and research platforms.