Adjusted current spread

What Is Adjusted Current Spread?

The Adjusted Current Spread is a financial metric used primarily within Fixed Income Analysis to evaluate the relative value of a fixed-income security, particularly those with complex features or embedded options. Conceptually, it represents the additional yield an investor demands above a benchmark yield curve to compensate for various risks, after accounting for specific characteristics of the security. Unlike a simple yield spread, the Adjusted Current Spread seeks to refine this compensation by incorporating the impact of factors such as interest rate volatility and the potential exercise of embedded options, offering a more nuanced view of the security's true risk-adjusted return. This measure is crucial for investors assessing the attractiveness of bonds, especially those with features like prepayment options or call provisions, as it provides a more accurate reflection of the spread after these adjustments. The Adjusted Current Spread aims to present a clearer picture of the spread attributable solely to credit and liquidity risks by isolating the influence of these complex features.

History and Origin

The concept of evaluating the spread of a bond over a risk-free rate has been a cornerstone of fixed-income valuation for decades, evolving from simple yield-to-maturity comparisons to more sophisticated models. The informal use of Treasury credit spreads dates back to the late 1800s, becoming fully incorporated into bond relative-value analysis by the 1960s.¹⁸ The development of term structure modeling techniques in the 1970s, which aimed to model a risk-free yield curve, provided the foundation for more advanced methods of deriving credit spreads.¹⁷

The need for "adjusted" spreads became particularly pronounced with the growth of securities featuring embedded options, such as mortgage-backed securities (MBS) and callable bonds. MBS, for instance, gained significant traction after the creation of the Government National Mortgage Association (Ginnie Mae) in 1970, which allowed banks to sell mortgages to third parties, thus fueling the securitization process. The complex cash flow behavior of these securities, influenced by borrowers' prepayment options, necessitated valuation models that could account for future interest rate scenarios and their impact on these options. This led to the evolution of measures like the Option-Adjusted Spread (OAS), which explicitly removes the value of embedded options from the bond's overall spread, providing a more refined "adjusted" measure of the yield premium.¹⁶ The extensive growth in the MBS market, with issuances exceeding $9 trillion by 2010, further spurred innovations in valuation methods, including the development and refinement of adjusted spread calculations to accurately price and manage the risks of these complex instruments.¹⁵

Key Takeaways

• The Adjusted Current Spread is a sophisticated measure in fixed-income analysis that accounts for specific features of a bond, such as embedded options, to provide a more accurate risk-adjusted yield spread.
• It helps investors compare complex securities by isolating the spread due to credit and liquidity risks from the influence of optionality and interest rate volatility.
• Calculation typically involves dynamic pricing models, often employing simulation techniques to project cash flows across various interest rate scenarios.
• A higher Adjusted Current Spread for a given credit quality may suggest that a bond is undervalued, offering greater compensation for its inherent risks.
• It is particularly vital for evaluating mortgage-backed securities (MBS) and callable bonds, where prepayment risk and call risk significantly impact cash flows.

Formula and Calculation

While "Adjusted Current Spread" may not refer to a single, universally adopted formula distinct from other advanced spread measures, the concept of an "adjusted" spread most prominently manifests in the calculation of the Option-Adjusted Spread (OAS). OAS is often considered the primary form of an "adjusted spread" in bond valuation because it explicitly adjusts for the impact of embedded options. The general relationship is expressed as:

Here:

• Z-Spread (Zero-Volatility Spread) is the constant spread that, when added to each point on the benchmark spot yield curve, makes the present value of a bond's cash flows equal to its market price. The Z-spread does not account for embedded options.¹⁴
• Option Cost represents the value of the embedded option (e.g., call option, put option, prepayment option). This cost is typically determined through complex valuation models, such as binomial trees or Monte Carlo simulations, which consider various interest rate paths and the probability of the option being exercised., The option cost is subtracted from the Z-spread because embedded options usually benefit the issuer (like a call option, allowing them to refinance at lower rates) or the borrower (like prepayment, allowing them to refinance their mortgage), thus reducing the effective yield to the investor.

The calculation of the Adjusted Current Spread (as represented by OAS) for a security like a mortgage-backed security (MBS) involves several steps:

1. Generate Interest Rate Paths: Using a model (e.g., binomial tree or Monte Carlo simulation), generate numerous possible future interest rate paths.¹³,
2. Project Cash Flows: For each interest rate path, project the bond's cash flows, taking into account the potential exercise of embedded options (e.g., prepayments on MBS if interest rates fall, or calls on callable bonds if rates fall).
3. Calculate Present Value: Discount the projected cash flows for each path back to the present using the risk-free rate plus a trial spread.
4. Iterate to Find OAS: Adjust the trial spread until the average present value of cash flows across all simulated paths equals the bond's current market price. This spread is the Option-Adjusted Spread.¹²

This iterative process is essential because the cash flows of securities with embedded options are not fixed; they are path-dependent, meaning they change based on how interest rates evolve over time.

Interpreting the Adjusted Current Spread

Interpreting the Adjusted Current Spread, particularly in the form of an Option-Adjusted Spread (OAS), provides critical insights into a bond's relative value and inherent risks. A bond's OAS is the yield premium that an investor receives for holding a bond with embedded options, after accounting for the value of those options. It aims to represent the compensation for credit risk and liquidity risk.

A higher Adjusted Current Spread (OAS) generally indicates that the bond offers a greater potential return for the same level of non-option-related risk. If two bonds have similar credit quality, maturity, and other characteristics, the one with a higher OAS is often considered relatively "cheap" or undervalued, suggesting it might be an attractive investment. Conversely, a lower OAS may indicate that the bond is "expensive" or overvalued, offering less compensation for its risks.¹¹

For mortgage-backed securities (MBS), the Adjusted Current Spread is especially important. MBS are subject to prepayment risk, where homeowners refinance their mortgages when interest rates decline. This early repayment of principal can reduce the total interest received by MBS investors. The Adjusted Current Spread (OAS) explicitly incorporates the expected impact of such prepayments, providing a more realistic yield comparison than traditional yield measures. Similarly, for callable bonds, which allow the issuer to redeem the bond before maturity, the OAS accounts for the cost of this embedded call option to the investor, offering a clearer picture of the bond's yield relative to its non-callable counterparts.¹⁰

Investors use this adjusted spread to determine if they are adequately compensated for the unique risks associated with the bond's structure. It helps in identifying mispricings and making informed allocation decisions within a diversified bond portfolio.

Hypothetical Example

Consider two hypothetical bonds, Bond A and Bond B, both with a face value of $1,000, a 5-year maturity, and a 4% coupon rate. Assume the current risk-free yield curve is flat at 2%.

Bond A: A straight, non-callable corporate bond.

• Z-Spread Calculation: After discounting its cash flows using the risk-free curve and iterating, let's say Bond A has a Z-spread of 150 basis points (bps).
• Adjusted Current Spread (OAS): Since Bond A has no embedded options, its Option Cost is effectively zero. Therefore, its Adjusted Current Spread (OAS) is equal to its Z-spread: 150 bps. This means investors require an additional 1.50% above the risk-free rate for the credit and liquidity risk of Bond A.

Bond B: A corporate bond with an embedded call option, allowing the issuer to call it back after 3 years if interest rates fall significantly.

• Z-Spread Calculation: Due to its similar credit profile, let's assume Bond B also has a Z-spread of 170 bps, which is higher than Bond A's Z-spread because it accounts for the potential impact of the call option (which is a disadvantage to the investor if exercised).
• Option Cost Calculation: Through a Monte Carlo simulation, the estimated Option Cost (the value of the issuer's call option) is determined to be 30 bps. This 30 bps represents the compensation investors effectively give up for the issuer's flexibility.
• Adjusted Current Spread (OAS): The Adjusted Current Spread for Bond B is calculated as:
  OAS = Z-Spread - Option Cost
  OAS = 170 bps - 30 bps = 140 bps

Interpretation:
Even though Bond B has a higher Z-spread (170 bps vs. 150 bps for Bond A), its Adjusted Current Spread (OAS) is lower (140 bps vs. 150 bps for Bond A). This implies that after accounting for the value of the embedded call option, Bond B offers less true compensation for its credit risk compared to Bond A. An investor might consider Bond A to be relatively more attractive on a risk-adjusted basis because its Adjusted Current Spread is higher, indicating a better return for similar credit risk when the optionality is factored out. This highlights how an Adjusted Current Spread provides a deeper understanding of a bond's intrinsic value by isolating the spread due to credit and liquidity risk.

Practical Applications

The Adjusted Current Spread, often synonymous with Option-Adjusted Spread (OAS) in practice, has several key applications across fixed-income markets:

• Relative Value Analysis: Investors widely use the Adjusted Current Spread to compare the relative attractiveness of different fixed-income securities, especially those with varying embedded options. By stripping out the value attributable to these options, it allows for a more "apples-to-apples" comparison of the underlying credit and liquidity premiums. For instance, bond analysts can compare the Adjusted Current Spread of various mortgage-backed securities (MBS) or asset-backed securities (ABS) to identify which offers the most compelling value for the inherent risks.
• Portfolio Management: Fixed-income portfolio managers leverage the Adjusted Current Spread to construct and manage portfolios. They can use it to gauge whether the compensation for taking on credit risk is sufficient relative to market conditions and their investment objectives. A manager might seek to increase exposure to sectors with wider Adjusted Current Spreads, believing these offer better risk-adjusted returns. The ICE BofA US High Yield Index Option-Adjusted Spread, for example, provides a benchmark for evaluating the overall level of compensation available in the high-yield bond market.⁹
• Risk Management: The Adjusted Current Spread helps in understanding and quantifying the risk components within a bond. By separating the option cost from the overall yield spread, it allows for better management of interest rate risk and specific risks associated with embedded features. Active managers of spread-based fixed-income portfolios use this to position their portfolios to capitalize on market views while managing credit exposures.⁸
• Pricing and Trading: In trading desks, Adjusted Current Spreads are critical for pricing complex bonds and executing trades. They provide a quantitative basis for determining fair value, which is essential for market makers and institutional investors. Discrepancies between a bond's actual yield and its implied Adjusted Current Spread can signal trading opportunities.

Limitations and Criticisms

Despite its utility, the Adjusted Current Spread, particularly as an Option-Adjusted Spread (OAS), comes with several limitations and criticisms:

• Model Dependence: A significant drawback is its reliance on complex pricing models, often involving Monte Carlo simulations or binomial trees, to project future cash flows and interest rate paths. The accuracy of the Adjusted Current Spread is highly sensitive to the assumptions fed into these models, including assumptions about future interest rate volatility and prepayment behavior. If these assumptions are flawed or do not accurately reflect market realities, the calculated spread can be misleading.
• Complexity and Opacity: The sophisticated nature of its calculation can make the Adjusted Current Spread opaque and difficult for non-experts to fully understand. This lack of transparency can hinder intuitive interpretation and comparison, especially when different models or assumptions are used by various market participants.
• Prepayment Model Risk: For mortgage-backed securities (MBS), the Adjusted Current Spread's accuracy heavily depends on the underlying prepayment model. Prepayment behavior, driven by factors like refinancing incentives and economic conditions, is complex and difficult to predict perfectly. Errors in forecasting prepayments can lead to inaccurate Adjusted Current Spreads.⁷
• Market Illiquidity: In thinly traded or illiquid markets, obtaining reliable input data for Adjusted Current Spread calculations can be challenging, leading to skewed results.⁶ The market price, a key input, may not always reflect true value in illiquid segments, thereby affecting the accuracy of the derived spread.
• Assumption of Parallel Shifts: While more advanced than simpler spread measures, some analyses built on spread assumptions may not fully capture non-parallel shifts in the yield curve, which can occur during periods of economic instability.⁵
• Limited Scope for Non-Yield Factors: The Adjusted Current Spread primarily focuses on yield-related compensation for risk. It may not fully capture other non-interest rate factors that influence a bond's price and risk, such as specific legal covenants, embedded credit guarantees, or idiosyncratic issuer-specific events.

These limitations mean that while the Adjusted Current Spread is a powerful analytical tool, it should be used in conjunction with other metrics and a thorough understanding of the underlying security and market conditions. For instance, the CFA Institute highlights that while yield spreads compensate for credit risk, other risks like market and interest rate risks also influence the spread, and should be considered.⁴

Adjusted Current Spread vs. Option-Adjusted Spread (OAS)

The terms "Adjusted Current Spread" and "Option-Adjusted Spread (OAS)" are often used interchangeably or with "Adjusted Current Spread" serving as a more general umbrella term for any spread that has been refined to account for specific bond characteristics. However, in fixed-income finance, OAS is the most widely recognized and rigorously defined method of calculating an "adjusted spread."

The primary distinction lies in precision and common usage. Option-Adjusted Spread (OAS) specifically measures the yield spread of a bond over a benchmark yield curve, after factoring in the value of any embedded options (such as call or put features, or prepayment options in mortgage-backed securities). Its calculation explicitly removes the "option cost" from a base spread like the Z-spread, providing a truer measure of the compensation for credit and liquidity risk. It is a dynamic model that considers how cash flows might change across various interest rate scenarios.

Adjusted Current Spread, on the other hand, can sometimes refer more broadly to any spread that has been modified from a raw yield difference to account for certain factors. While it most commonly refers to OAS in discussions of bond valuation with embedded options, the phrase "adjusted spread" can also appear in other contexts, such as contractual definitions where a benchmark rate is adjusted by a specific percentage.³ However, for the purpose of analyzing the risk and return of a security with embedded optionality, OAS is the precise and widely accepted methodology for calculating an "adjusted spread." The confusion often arises because OAS is, by its very definition, an "adjusted" spread.

FAQs

What does "Adjusted Current Spread" tell an investor?

The Adjusted Current Spread (typically meaning Option-Adjusted Spread or OAS) tells an investor the additional yield they receive above a risk-free benchmark, after accounting for the impact of any embedded options in the bond. It helps gauge the compensation for the bond's credit and liquidity risks, making it easier to compare complex securities.²

Is Adjusted Current Spread the same as Option-Adjusted Spread (OAS)?

In the context of bond valuation, "Adjusted Current Spread" is most often referring to or used synonymously with Option-Adjusted Spread (OAS). OAS is the specific, widely adopted methodology that adjusts a bond's spread for the value of its embedded options.

Why is an Adjusted Current Spread (OAS) important for bonds with embedded options?

It's important because bonds with embedded options, like callable bonds or mortgage-backed securities (MBS), have uncertain cash flows. Their value and effective yield are significantly affected by the likelihood of these options being exercised. The Adjusted Current Spread (OAS) accounts for these complexities, providing a more accurate measure of the bond's true yield compensation relative to a risk-free bond.

How does interest rate volatility affect the Adjusted Current Spread (OAS)?

Interest rate volatility is a key component in calculating the Adjusted Current Spread (OAS). Higher volatility increases the uncertainty surrounding future cash flows for bonds with embedded options. For example, if a bond is callable, higher volatility means a greater chance the issuer will call the bond, which typically reduces the OAS for the investor.¹

Does the Adjusted Current Spread apply to all types of bonds?

While the concept of adjusting a spread for risk factors applies broadly, the rigorous calculation of an Adjusted Current Spread (like OAS) is most relevant and frequently applied to bonds with embedded options, such as mortgage-backed securities (MBS), callable corporate bonds, and other asset-backed securities. For simple, plain vanilla bonds without embedded options, simpler spread measures like the Z-spread are typically sufficient, as the option cost component would be zero.