What Is Adjusted Free Spread?
The Adjusted Free Spread is a conceptual metric in fixed income analysis that aims to provide a more precise measure of a security's yield premium by accounting for factors beyond simple credit risk. While not a universally standardized term, this concept is most closely aligned with, and often refers to, the Option-Adjusted Spread (OAS). In essence, an Adjusted Free Spread quantifies the additional yield an investor demands above a risk-free rate for holding a fixed-income security, particularly those with embedded options, after adjusting for the value of those options. It is expressed in basis points and offers a more comprehensive view of the true compensation for risk, isolating the inherent credit exposure from the influence of embedded features. This adjusted spread metric is crucial for accurate bond valuation and for comparing different types of debt instruments.
History and Origin
The concept underlying the Adjusted Free Spread, particularly the Option-Adjusted Spread (OAS), emerged from the need for more sophisticated analytical tools to evaluate fixed-income securities with complex characteristics. Traditional spread measures, such as the nominal spread or G-spread, simply compare a bond's yield to a benchmark without accounting for the potential impact of embedded features like call or put options. As the bond market evolved and the complexity of debt instruments increased, especially with the proliferation of mortgage-backed securities (MBS) in the late 20th century, these simpler measures proved inadequate. MBS, for instance, introduced significant prepayment risk due to borrowers' ability to refinance their mortgages.
Academics and practitioners began developing dynamic pricing models that could incorporate the probabilistic nature of these embedded options and their impact on a bond's cash flows. This led to the formalization of the Option-Adjusted Spread. Researchers have noted that OAS is a mathematical construct developed to align a security's model-estimated price with its actual market price, especially when conventional risk-neutral models fall short without such an adjustment.24 The development of term structure modeling techniques in the 1970s further catalyzed the creation of advanced methods for deriving credit spreads, paving the way for option-adjusted methodologies.23
Key Takeaways
- The Adjusted Free Spread, typically referring to the Option-Adjusted Spread (OAS), measures the yield premium of a bond over a risk-free rate, after accounting for the impact of any embedded options.
- It provides a more accurate assessment of a bond's inherent credit risk by separating it from the volatility introduced by embedded options.
- Unlike simpler yield spreads, the Adjusted Free Spread uses dynamic pricing models that consider various interest rate paths and potential changes in cash flows due to option exercise.
- A higher Adjusted Free Spread generally indicates a greater yield compensation for the non-option related risks of the security.
- It is particularly vital for evaluating complex fixed-income instruments like callable bonds and mortgage-backed securities.
Formula and Calculation
The calculation of the Adjusted Free Spread, or Option-Adjusted Spread (OAS), is complex because it involves dynamic modeling to account for the potential exercise of embedded options under various interest rate scenarios. Unlike static spread measures, OAS cannot be derived with a simple formula. Instead, it typically requires sophisticated financial models, such as binomial trees or Monte Carlo simulations, to project future cash flows across a multitude of possible yield curve movements.,22
Conceptually, the OAS is the constant spread that, when added to each point on the benchmark yield curve (e.g., the Treasury spot rate curve), equates the theoretical value of a bond, derived from discounting its option-adjusted cash flows, to its current market price.
The general relationship can be represented as:
Here:
- (\text{Market Price}) = The current observed market price of the bond.
- (\text{Expected Cash Flow}_t) = The projected cash flow at time (t), adjusted for the probability of option exercise (e.g., prepayment, call, or put options) under various interest rate scenarios.
- (\text{Risk-Free Rate}_t) = The corresponding spot rate on the benchmark yield curve for time (t).
- (\text{OAS}) = The Option-Adjusted Spread, which is the value being solved for.
- (N) = The number of cash flows until maturity.
For callable bonds, the OAS is typically lower than the Z-spread because the call option benefits the issuer, reducing the bond's value to the investor. Conversely, for bonds with put options (which benefit the investor), the OAS would be higher than the Z-spread.21
Interpreting the Adjusted Free Spread
Interpreting the Adjusted Free Spread involves understanding that it represents the compensation an investor receives for bearing risks other than the embedded option risk. A higher Adjusted Free Spread (OAS) implies a greater expected return for a given level of non-option related risk. When comparing two bonds, the one with a higher OAS is generally considered more attractive, assuming all other factors like credit risk and liquidity are comparable, because it offers more compensation for the risks it carries.20,19
For example, a positive Adjusted Free Spread indicates that the bond offers a yield premium over the risk-free rate, after accounting for the embedded option. A negative OAS, while less common for typical corporate bonds, could suggest that the bond's embedded options are so valuable to the issuer (or detrimental to the investor) that the bond offers a lower expected return than a comparable risk-free security, even after factoring in its credit risk.18,17
This metric allows investors to gauge the relative value of complex fixed-income securities more accurately than simpler spread measures.
Hypothetical Example
Consider two hypothetical mortgage-backed securities (MBS), MBS A and MBS B, both with similar maturities and underlying mortgage pools.
- MBS A has a stated yield of 4.5%.
- MBS B has a stated yield of 4.3%.
Based solely on yield, MBS A appears more attractive. However, MBS typically have prepayment risk because homeowners can refinance their mortgages when interest rates fall. To properly compare these two, we calculate their Adjusted Free Spreads (OAS).
Using a sophisticated valuation model that simulates various interest rate environments and prepayment behaviors:
- Calculate MBS A's OAS: After running the model, MBS A's OAS is determined to be 75 basis points. This means that after adjusting for the value of its embedded prepayment options, MBS A offers a 0.75% premium over the benchmark yield curve.
- Calculate MBS B's OAS: The model calculates MBS B's OAS at 85 basis points. This implies MBS B offers a 0.85% premium over the benchmark, adjusted for its prepayment options.
Even though MBS A had a higher stated yield, its Adjusted Free Spread (OAS) is lower. This suggests that the embedded prepayment options in MBS A are more detrimental to the investor, or perhaps its credit profile, when isolated from the option effect, is less appealing than initially perceived by the raw yield. Therefore, MBS B, despite its lower stated yield, offers better compensation for its inherent risks excluding the option effect, making it potentially a more attractive investment on a risk-adjusted basis. This demonstrates how the Adjusted Free Spread provides a clearer picture for informed decision-making.
Practical Applications
The Adjusted Free Spread (OAS) is a vital tool in modern finance, particularly within portfolio management and bond trading. It enables investors and analysts to make more informed decisions by providing a risk-adjusted measure of return for fixed-income securities that contain embedded options.
One primary application is in evaluating and comparing bonds with varying embedded features. For instance, when choosing between a callable bond and a non-callable bond, the OAS helps to "level the playing field" by stripping out the value attributable to the call option, thereby allowing for a direct comparison of their inherent credit risk and liquidity.16,15 Fund managers use the OAS to identify relative value opportunities, seeking bonds that offer a higher OAS for a given level of credit quality, as this suggests the bond may be undervalued.14,13
Furthermore, the Adjusted Free Spread is critical in the analysis of mortgage-backed securities, where prepayment risk is a significant factor. It helps investors understand the true yield compensation after accounting for the uncertainty of mortgage prepayments.12 The Federal Reserve's economic data, such as the ICE BofA US High Yield Index Option-Adjusted Spread, provides real-world examples of how this metric is tracked and used by market participants to gauge overall market risk and sentiment in the high-yield bond segment.11
Limitations and Criticisms
While the Adjusted Free Spread (OAS) offers significant advantages in analyzing complex fixed-income securities, it is not without limitations. A primary criticism is its reliance on complex and often subjective modeling assumptions.10,9 The calculation of OAS requires a dynamic interest rate model and assumptions about the behavior of embedded options (e.g., prepayment speeds for MBS or call probabilities for callable bonds), which are inherently difficult to predict accurately., These models use historical data to estimate future interest rate volatility and prepayment rates, but past performance is not indicative of future results, and unforeseen economic shifts can render these assumptions less reliable.8,7
Another limitation is that the OAS is model-dependent, meaning different models or inputs can produce different Adjusted Free Spread values for the same security. This can lead to inconsistencies and make direct comparisons across analyses challenging.6 Moreover, while OAS aims to isolate option risk, it may not fully capture other relevant risks like liquidity risk or specific issuer-related risks not explicitly modeled.5 Some academics argue that the existence of OAS can be symptomatic of a misspecified prepayment model rather than purely an expected risk premium compensation.4 Therefore, investors should use Adjusted Free Spread in conjunction with other metrics and qualitative analysis.
Adjusted Free Spread vs. Z-Spread
The Adjusted Free Spread, primarily referring to the Option-Adjusted Spread (OAS), is often contrasted with the Z-spread (Zero-Volatility Spread) due to their distinct approaches to handling embedded options. Both are measures of yield spread over a benchmark yield curve.
The Z-spread is the constant spread that, when added to each point on the benchmark spot rate curve, makes the present value of a bond's contractual cash flows equal to its market price. It is called "zero-volatility" because it assumes interest rate volatility is zero and does not account for any embedded options or their potential impact on cash flows. Therefore, the Z-spread reflects both the credit risk of the bond and the cost or benefit of any embedded options.,3
In contrast, the Adjusted Free Spread (OAS) refines the Z-spread by explicitly factoring in the value of these embedded options. It is the spread that remains after subtracting the option cost (or adding the option benefit) from the Z-spread.2 This means the Adjusted Free Spread (OAS) aims to isolate the portion of the yield premium that compensates for non-option related risks, primarily credit and liquidity risks. For a bond with no embedded options, the Adjusted Free Spread (OAS) and the Z-spread would be identical. However, for a callable bond, where the option benefits the issuer, the OAS will be less than the Z-spread. For a bond with a put options, where the option benefits the investor, the OAS will be greater than the Z-spread.1
FAQs
What does "Adjusted Free Spread" mean in simple terms?
In simple terms, "Adjusted Free Spread" is a way to figure out how much extra yield you're getting from a bond beyond a basic risk-free rate, especially when that bond has special features (like the ability for the issuer to buy it back early, or for you to sell it back early). It tries to give you the "pure" extra yield for the bond's credit risk, separate from those special features. The most common and formal term for this is Option-Adjusted Spread (OAS).
Why is an Adjusted Free Spread important for investors?
It's important because many bonds aren't straightforward; they have embedded options that can change their actual cash flows. A traditional yield might look good, but if the bond has a call option, the issuer might pay it back early when interest rates fall, cutting your expected returns. The Adjusted Free Spread (OAS) helps investors see the true compensation for the bond's risks, making it easier to compare complex fixed-income securities on a more apples-to-apples basis.
How does an Adjusted Free Spread account for embedded options?
The Adjusted Free Spread (OAS) uses sophisticated computer models, like simulation or tree models, to forecast how a bond's cash flows might change under different future interest rate scenarios, taking into account when and if those embedded options would likely be exercised. It then finds a spread that, when added to the risk-free rate, makes the bond's theoretical price match its current market price, effectively "adjusting" for the value of those options.
Is a higher Adjusted Free Spread always better?
Generally, a higher Adjusted Free Spread (OAS) is considered better because it implies a greater yield premium for the non-option related risks of the security. It means you are being more amply compensated for the bond's credit risk and other inherent risks, after stripping out the effects of the embedded options. However, it's crucial to always consider why the spread is high—it might indicate higher underlying risks or specific market conditions.
What are common examples of securities where Adjusted Free Spread is used?
The Adjusted Free Spread (OAS) is most commonly used for fixed-income securities that have embedded options. Key examples include mortgage-backed securities (MBS), which have prepayment risk, and callable bonds or put options, which give the issuer or investor the right to redeem or sell the bond early. It is less relevant for "plain vanilla" bonds without such features.