Adjusted spread

What Is Adjusted Spread?

Adjusted Spread, commonly known as the Option-Adjusted Spread (OAS), is a measurement used in fixed-income analysis that quantifies the difference in yield between a fixed-income security and a benchmark risk-free rate, while also accounting for the impact of any embedded option within the security. It essentially represents the additional yield an investor receives for taking on the risks associated with a bond, excluding the impact of embedded options. The Adjusted Spread helps investors evaluate the relative value of bonds, especially those with complex features like embedded call or put options, by isolating the compensation for credit and liquidity risks from the value attributable to these options.

History and Origin

The concept of Option-Adjusted Spread emerged as financial markets grew in complexity, particularly with the proliferation of mortgage-backed securities (MBS) in the 1980s. These securities introduced significant prepayment risk due to homeowners' ability to refinance their mortgages, effectively acting as an embedded option. Traditional yield measures, such as yield to maturity, proved inadequate for valuing bonds with such dynamic cash flows. To address this, sophisticated bond valuation models were developed that could account for future interest rate paths and the probability of option exercise. The Adjusted Spread, or OAS, became a crucial output of these models, serving as a "mathematical construct" to align the model-derived theoretical price of a bond with its actual market price. Its development was critical for better understanding and pricing complex instruments where cash flows were not static but rather dependent on market conditions and borrower behavior.¹³

Key Takeaways

• Option-Adjusted Spread (OAS) quantifies the yield difference between a bond with an embedded option and a risk-free benchmark, isolating the option's effect.
• OAS is particularly useful for valuing complex securities like mortgage-backed securities and callable bonds or putable bonds.
• It is calculated using dynamic pricing models that simulate various interest rate scenarios and prepayment behaviors.
• A higher OAS generally suggests a greater potential return for the assumed credit and liquidity risks, after accounting for the embedded option.
• OAS is expressed in basis points, representing the spread over the benchmark yield curve.

Formula and Calculation

The calculation of the Adjusted Spread (OAS) is complex and typically involves sophisticated analytical models, often employing Monte Carlo simulation or binomial/trinomial trees. At its core, OAS is derived from the bond's market price and its projected cash flows across numerous simulated interest rate paths, with adjustments for the embedded option's value. Conceptually, it can be viewed as the spread that, when added to each point on the benchmark yield curve (such as the Treasury securities curve), equates the theoretical present value of the bond's expected cash flows to its market price, with the option's value explicitly factored in.

A simplified conceptual representation often shows the relationship between OAS, Z-spread (zero-volatility spread), and the option cost:

$\text{OAS} = \text{Z-Spread} - \text{Option Cost}$

Where:

• (\text{OAS}) is the Option-Adjusted Spread.
• (\text{Z-Spread}) is the zero-volatility spread, which is the constant spread that must be added to the benchmark spot rate curve to make the present value of a bond's cash flows equal to its market price, without accounting for embedded options.
• (\text{Option Cost}) is the value attributed to the embedded option. For a callable bond, the option benefits the issuer (reducing the bond's value for the investor), so the option cost is positive, leading to OAS < Z-Spread. For a putable bond, the option benefits the investor, making the option cost negative, leading to OAS > Z-Spread.¹²,¹¹

Interpreting the Adjusted Spread

Interpreting the Adjusted Spread involves understanding that it represents the yield premium an investor receives for bearing credit risk and liquidity risk, after removing the influence of embedded options. A higher OAS for a given bond generally suggests that it offers a greater compensation for these non-option-related risks, making it potentially more attractive if the investor is comfortable with those risks. Conversely, a lower OAS might indicate that the bond offers less compensation or is relatively expensive.

Analysts often compare the OAS of different bonds to assess their relative value. For instance, if two bonds have similar credit quality, maturity, and other characteristics but one has a significantly higher OAS, it might be considered "cheap" or undervalued relative to the other. This allows for a more "apples-to-apples" comparison among securities, especially when they possess different types of embedded options. It provides a measure of expected outperformance versus benchmarks if the cash flows and the yield curve behave consistently with the valuation model.,¹⁰

Hypothetical Example

Consider two hypothetical mortgage-backed securities (MBS), MBS Alpha and MBS Beta, both with an estimated maturity of 10 years and similar underlying mortgage pools.

• MBS Alpha: Has a current market price of $980 and, after running through a sophisticated OAS model, is determined to have an Option-Adjusted Spread of 150 basis points over the benchmark Treasury curve.
• MBS Beta: Has a current market price of $975 and, through the same modeling process, is found to have an Option-Adjusted Spread of 120 basis points over the same benchmark.

In this scenario, even though MBS Alpha has a slightly higher price, its OAS of 150 basis points is higher than MBS Beta's 120 basis points. This suggests that, after accounting for their respective embedded prepayment options and other complex features, MBS Alpha offers a greater yield premium for its inherent credit and liquidity risks compared to MBS Beta. An investor seeking higher compensation for these risks might find MBS Alpha more appealing on an option-adjusted basis. This allows for a more informed assessment beyond simply comparing nominal yields or prices.

Practical Applications

The Adjusted Spread (OAS) is extensively used across various segments of the financial market, particularly in fixed income. Its primary applications include:

• Relative Value Analysis: Investors and portfolio managers use OAS to compare the attractiveness of different fixed-income securityies, especially those with embedded options. By stripping out the value of the option, OAS allows for a clearer comparison of bonds based on their fundamental credit and liquidity characteristics. This is crucial for portfolio allocation decisions.
• Bond Pricing and Valuation: OAS is integral to accurately pricing bonds with embedded options, such as callable, putable, or convertible bonds, and complex structures like mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs). It helps determine a fair market price by accounting for the dynamic nature of their cash flows.
• Risk Management: By providing a more precise measure of a bond's yield premium adjusted for optionality, OAS helps in assessing and managing interest rate risk and prepayment risk. It allows analysts to understand how changes in interest rate volatility might impact a bond's value.
• Index Construction and Benchmarking: Major bond index providers utilize OAS in constructing their indices, particularly for sectors with prevalent embedded options like the high-yield market. For example, the ICE BofA US High Yield Index Option-Adjusted Spread provides a widely followed measure of the overall risk premium in the high-yield debt market.⁹,⁸, The methodologies for such indices often detail how OAS is incorporated to ensure accurate representation of market segments.⁷

Limitations and Criticisms

While the Adjusted Spread (OAS) is a powerful tool for bond pricing and analysis, it is not without limitations. A significant criticism is its model dependence. The accuracy of OAS calculations relies heavily on the assumptions and methodologies used in the underlying pricing models, particularly regarding future interest rate volatility and, for mortgage-backed securities, prepayment behavior.⁶, If these assumptions are flawed or the model itself is misspecified, the resulting OAS may provide a distorted picture of the bond's true value.⁵,⁴

Other potential drawbacks include:

• Sensitivity to Input Data: OAS can be highly sensitive to the quality and precision of input data, such as market prices, Treasury yields, and estimated prepayment speeds. Small changes in these inputs can lead to significant variations in the calculated OAS.
• Difficulty in Interpretation for Non-Experts: The complex nature of its calculation can make the Adjusted Spread challenging for non-specialists to fully understand and interpret, potentially leading to misjudgments in investment decisions.³
• Ignoring Default Option: While OAS models can, in principle, incorporate default risk, in practice, some models might subsume it into the OAS rather than modeling it explicitly, which could lead to an incomplete risk assessment.²
• Historical Bias: Models often rely on historical data to estimate future volatility and prepayment rates. However, economic and market conditions can change, rendering historical patterns less reliable for predicting future behavior.

Adjusted Spread vs. Z-Spread

The Adjusted Spread (OAS) and the Z-spread are both measures of credit and liquidity risk premium over a benchmark yield curve, but they differ fundamentally in how they treat embedded options.

The Z-spread, or zero-volatility spread, represents the constant spread that, when added to each point on the benchmark Treasury spot rate curve, makes the present value of a bond's contractual cash flows equal to its current market price. Crucially, the Z-spread does not account for the impact of any embedded options that might alter the bond's cash flows, such as call or put features. It assumes static cash flows regardless of future interest rate movements.,

In contrast, the Adjusted Spread (OAS) takes the Z-spread a step further by explicitly adjusting for the value of embedded options. It incorporates a dynamic pricing model that simulates how changes in interest rate volatility and the likelihood of option exercise (e.g., bond calls or mortgage prepayments) can affect the bond's future cash flows and, consequently, its value. This adjustment allows the OAS to provide a more accurate and "option-neutral" measure of the yield premium attributable solely to the bond's credit risk and liquidity risk. For a bond with a callable feature (which benefits the issuer), its OAS will typically be lower than its Z-spread because the option's value is subtracted. For a putable bond (which benefits the investor), its OAS will be higher than its Z-spread.¹

FAQs

What type of bonds is Adjusted Spread most relevant for?

Adjusted Spread (OAS) is most relevant for bonds that contain embedded options, such as mortgage-backed securities, callable bonds, and putable bonds. These are securities where the future cash flows can change based on the actions of the issuer or bondholder in response to market conditions.

Is a higher Adjusted Spread always better?

A higher Adjusted Spread generally indicates a greater yield premium for the risks taken, after accounting for embedded options. However, it's essential to understand why the OAS is higher. It could be due to higher inherent credit risk or liquidity risk of the bond, which an investor must be willing to accept. Comparing OAS values requires careful consideration of all relevant bond characteristics.

How does interest rate volatility affect Adjusted Spread?

Interest rate volatility is a key factor in calculating the Adjusted Spread. Higher volatility can increase the uncertainty around a bond's future cash flows, particularly for bonds with embedded options. For example, in a highly volatile interest rate environment, the likelihood of a callable bond being called or a mortgage being prepaid (due to prepayment risk) can change significantly, which the OAS calculation attempts to capture.

Can Adjusted Spread be negative?

No, the Option-Adjusted Spread cannot be negative. OAS represents a spread over a risk-free benchmark to account for credit and liquidity risks. While it can be very small for highly creditworthy and liquid bonds, it will always be positive to compensate investors for these inherent risks.