Yield Curve − Option-Adjusted Spreads

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After this module, the learner will be able to:

1. Explain intuitively how option-adjusted spreads (OAS) and other spread measures are computed.

2. Outline in which circumstances each measure is used appropriately.

3. Explain how OAS depend on the interest rate volatility estimate and embedded option characteristics.

4. Explain how OAS are used for different types of securities.

5. Discuss strengths and weaknesses of the OAS concept.

1. Introduction
Corporate bonds need to offer a return premium to investors due to the existence of credit, liquidity, and option
risk. There are various ways to measure this return premium. The three most common measures are: nominal yield
spreads, zero-volatility spreads (Z-spreads), and option-adjusted spreads (OAS).

In the following, we outline the computation of each of these metrics and explain their uses. Certain types of
spreads are more appropriate than others depending on the type of bond.

2. Nominal Spreads
Objective: After this lesson, the learner will be able to explain why nominal spreads are generally not particularly
meaningful for bonds with embedded options.

For example, if a corporate bond has five years remaining to maturity and a yield to maturity of 6.5% while the
corresponding government bond with the same maturity yields 5.4%, then the nominal spread is equal to 110 basis
points (6.5% minus 5.4%).

A drawback associated with this type of spread measure is that it does not take into account the term structure of
spot rates for both bonds. In other words, all cash flows are discounted using the same rate. As shown in the graph
below, the nominal spread is added to the point on the yield curve that corresponds to the maturity of the bond being
analyzed (10 years in this example). As a result, the nominal spread does not allow proper comparison of two bonds
with different coupons even if the maturities or durations are the same.
Moreover, for bonds with embedded options, changing interest rates may alter the cash flow of the corporate bond,
a fact that is ignored by the nominal spread. Generally, bonds with embedded options are callable, so in the following
we will focus on callable bonds. However, the discussion below refers to any type of embedded option—for example,
a put option in a putable bond.

If the bond issuer decides to exercise his call option, the bond holder is going to forego any further coupon payments,
which will change the bond yield (in most cases, this will reduce bond yields). Therefore, nominal spreads are generally
not particularly meaningful for bonds with embedded options.

3. Zero-Volatility Spreads (Z-Spreads)

Objective: After this lesson, the learner will be able to describe the difference between the nominal spread and the
Z-spread and when the two are actually the same.

In other words, it is the yield spread over the spot rate curve that an investor in the corporate bond would realize. It
is computed by trial and error. This type of spread is called zero-volatility spread since it implicitly assumes that the
interest rate volatility is zero, which means that the embedded option in a callable bond has zero value since it is not
exercised. Hence, in a similar way as the nominal spread above, the Z-spread assumes that the bond's cash flows do
not change with the level of interest rates. Clearly, this is an unrealistic assumption for bonds with embedded
options. As a result, the Z-spread, while useful for callable bonds as a measure of total yield in a low volatility
scenario, doesn't specifically analyze the cost of the embedded call option.

The difference between the Z-spread and the nominal spread is the benchmark that is being used. The nominal
spread is added to the point on the yield curve that corresponds to the maturity of the bond being analyzed. In
contrast, the Z-spread is a constant that is added to each spot rate over the life of the bond analyzed. Therefore, in
the Z-spread calculation, each cash flow is discounted with a different interest rate as can be seen in the graph
below.

In most cases, the nominal spread and the Z-spread are of similar magnitude. If the spot rate curve is completely
flat, then the two spread measures are actually the same. The difference between the two measures increases as
the spot rate curve steepens.

4. Option-Adjusted Spread (OAS)

Objective: After this lesson, the learner will be able to state what interest rate models consist of, what they
commonly use to address interest rate changes over time, and how Z-spreads and OAS are related.

The OAS is computed in a similar manner as the Z-spread. In fact, one can think of it as the Z-spread that has been
adjusted for any option embedded in the bond.

For a callable bond (or any bond with an embedded option), we usually cannot compute the bond value simply by
discounting its future scheduled cash flows. Instead an interest rate model has to be used to value this type of bond,
as we have seen already in Module 2. This type of model takes into account the interest rate volatility and the fact
that the bond’s cash flows may change with the level of interest rates as the embedded option is exercised.

In general, an interest rate model is a probabilistic description of how interest rates can change during the life of a
bond, making certain assumptions about interest rate behavior. Binomial interest rate trees are most commonly
used for this purpose.

As we have seen in previous modules, binomial interest rate trees model how short-term interest rates change over
time. Given an interest rate as well as an interest rate volatility assumption, the binomial model assumes that
interest rates can realize one of two possible states over a given interval of time. By breaking up the time to maturity
of a bond into shorter time intervals (such as one year or half a year), the interest rate behavior during the life of the
bond can be modelled using a binomial interest rate tree. The following is an example of such a tree:

If the steps in the tree are annual, then this interest rate tree could be used to value a bond with a 4-year maturity
and annual coupon payments. Here the current one-year rate is 5.00%, and according to the interest rate model
used, the one-year rate could either increase to 6.24% or decrease to 4.18% over the next year, and so on. Again,
the values in the tree are based on the current yield curve as well as the interest rate volatility assumption.

Once an interest rate tree has been generated, the next step is to construct a bond price tree using the interest rate
tree. Here is an example of a bond price tree:

The bond price tree is constructed by successively discounting the bond's par value and coupon payments using the
rates from the interest rate tree and allowing for any embedded options.

A full description of different interest rate models that can be used to price bonds with embedded options is beyond
the scope of this text and most fixed−income practitioners do not need to know all the details and assumptions behind
these models, because they are generally provided by standard commercial packages. As a result, we take the interest
rate model as given for our OAS analysis.
The OAS is based on an interest rate model and takes future interest rate volatility into account. Hence, it recognizes
the fact that the bond's cash flows change depending on the future path of interest rates if the bond includes an
embedded option.

Just as with the Z-spread, the OAS is computed by trial and error and is the yield spread that, if added to the spot rate
curve, equates the bond value obtained from an interest rate model with the market price of the bond. In this sense,
as opposed to the nominal spread and the Z-spread, the OAS is model dependent. Different interest rate models used
will produce different OAS values for the bond with embedded options. More importantly, the interest rate volatility
estimates used as an input to the interest rate model have a significant impact on the value of the embedded option
and thereby on the OAS.

In essence, the OAS is computed in the same way as the Z-spread. However, it accounts for the optionality in the
bond with an embedded option. Because the Z-spread does not take this into account, one could label it the zero-
volatility OAS.

Alternatively, you can think of removing or stripping the call option from the callable bond and thereby create a
hypothetical option-free bond that is otherwise equivalent to the callable bond. The Z-spread would make the
model value of the hypothetical bond equal to the callable bond's market price and the OAS makes the callable bond
value obtained from the interest rate model equal to its market price.

Hence, we have the following relationship:

Because these types of spread measures are used for corporate bonds and are computed either relative to the
government yield curve (nominal spread) or the government spot rate curve (Z-spread and OAS), they always have to
be positive. If a government benchmark is used and the resulting spreads for corporate bonds end up being negative,
then there has to be an error in the valuation model or the methodology used to compute the spread. Corporate
bonds always have higher credit risk, liquidity risk, and option risk, than default free government bonds that are
option-free bonds.

5. Summary of Yield Spreads

Three types of yield spreads are commonly used: nominal spreads, zero-volatility spreads, and option-adjusted
spreads (OAS). They differ in the benchmark relative to which they are computed and they reflect compensation for
different types of risk:

• Nominal spreads: computed relative to the government yield curve, reflect compensation for credit risk,
liquidity risk, and option risk.

• Zero-volatility spreads: computed relative to the government spot rate curve, reflect compensation for credit
risk, liquidity risk, and option risk.

• OAS: removes the impact of the embedded options on the bond’s Z-spread. OAS reflect compensation only for
credit and liquidity risk.

6. Yield Spreads: A Practical Example

Mini file 5

1. Make the following inputs on the accompanying spreadsheet:

 2. After you have made those entries, press the “Build Tree” button first and then the “Solve for Z- Spread” and

“Solve for OAS” buttons.

3. The above inputs cause the spreadsheet to generate the interest rate tree, price the bonds based on that
tree, and then obtain the Z-spread and OAS that make the option-free and callable bond values equal to

their market prices.

4. The resulting values are as follows:

6.Analysis of Spreadsheet Computation of Yield Spreads

Objective: After this lesson, the learner will be able to describe how volatility affects the call option and how these
affect the option-adjusted spread (OAS).
The resulting nominal yield spread for the option-free bond is 179.18 basis points. Because the nominal yield spread
cannot accommodate changing cash flows for changing interest rates, it does not make sense to compute this
measure for bonds with embedded options.

The Z-spread is 179.86 basis points, very similar to the nominal spread. The similarity between these two metrics is
expected because the spot rate curve that we used is almost flat. At this point, you might want to experiment with
the spreadsheet to see how different shapes of the spot rate curve affect the difference between the nominal
spread and the Z-spread. As the spot rate curve steepens, the difference between the two should increase.

The Option-Adjusted Spread (OAS) for the callable bond that has the same characteristics as the option-free bond,
except for the callability, is 166.02 basis points. It is smaller than the corresponding Z-spread because for non-zero
interest rate volatilities the value of the embedded option is positive. Instead of the option value, the yield spread
that corresponds to the value of the option (labeled “Embedded Call Option Cost”), is shown in the last row of the
table below.

The embedded call option cost is 13.85 basis points, which is equal to the difference between the Z-spread and the
OAS as we have seen. So we have

It is important to emphasize again that the call option cost is heavily affected by the interest rate volatility estimate
used to price the option. Higher volatilities lead to higher option values and thus higher option costs in yield space.
From the above relation, the OAS will decrease with higher volatility assumptions.

7. Influence of Yield Volatility Assumption on OAS

Objective: After this lesson, the learner will be able to explain how a higher call strike price affects volatility and
OAS.

As we have seen in Module 2 already, people tend to use either historical volatilities or implied volatilities to come
up with an expected volatility. Historical volatilities are simply computed as the standard deviation of a historical
interest rate series. In contrast, implied volatilities are obtained from an option pricing model. To come up with an
implied volatility, an option embedded in a bond has to be assumed to be trading at its fair price and an option
pricing model has to be assumed to be the model which would generate that fair price. In this case, the implied
volatility is the volatility that would result in the option pricing model producing the fair price of the option, if the
implied volatility was used as an input. An advantage of the implied volatility approach is that it generates forward-
looking volatilities as opposed to past volatilities that are obtained from the historical volatility approach. Other
types of interest rate options that can be used to extract implied volatilities are caps / floors and collars as well as
swaptions (i.e., options that grant the holder the right to enter an interest rate swap).

Yield volatilities (particularly implied volatilities obtained from options prices) are typically quoted as relative
volatilities (Vol(Δy / y)) where y is the yield and Δy is a yield change, we have to multiply the volatility by the
corresponding yield level in order to obtain the type of volatility required.
As a next step, increase the call strike price from $100 to $102 in cell C8 and then press the “Build Tree” button first

and then the “Solve for Z-Spread” and “Solve for OAS” buttons.

What do you see? We expect the value of the embedded option or the call cost to decrease since the bond issuer
now has to pay $102 instead of $100 to call the bond. Therefore, the call option will be less valuable to him. The
”moneyness” of the option has been reduced. The new results confirm this expectation:

As a result of the higher call strike price, the option cost (to the bondholder) has been reduced from 13.85 basis
points to 3.97 basis points, resulting in an increase of the OAS from 166.02 basis points to 175.90 basis points.

8. OAS Analysis of Mortgage-Backed Securities

However, for MBS there is an additional step involved in addition to modeling the probabilistic behavior of
government spot rates, namely homeowners’ tendency to prepay their mortgages has to be modeled using
prepayment models. Therefore, we have an additional layer of uncertainty and the OAS is only a good measure of
value if homeowners exercise their prepayment option in a consistent and predictable manner.

Whether homeowners actually decide to prepay depends on a number of factors, not only the future interest rate
path.

• First, prepayment depends on whether it makes economic sense for them to do so, which, in turn, depends
among other things on the development of interest rates as well as a homeowner’s tax situation.

• Second, the decision to prepay depends on homeowners’ ability to refinance their mortgage at an
advantageous rate. In some cases, this might be unfeasible if, for example, their own credit situation has
deteriorated.

• Third, even if it makes economic sense for homeowners to prepay and they are able to do so, many
homeowners choose not to for personal reasons.

As a result, the decision to prepay is a lot more idiosyncratic than a corporate bond issuer’s decision to call the bond,
which is almost exclusively determined by interest rate factors. Again, the extent to which the OAS is helpful to value
MBS is highly dependent on how well prepayments can be modeled.

9. Advantages and Drawbacks of Different Yield Spread Measures

Objective: After this lesson, the learner will be able to describe the advantages and drawbacks of different yield
spreads. The following table gives an overview of the advantages and drawbacks of the different yield spread
measures discussed above:
 Advantages Disadvantage
Nominal Yield Spread Quantifies risk as implied Spread added to yield-to-
by the market maturity of bond so
bonds with different
coupons cannot be
compared
Does not accommodate
any embedded options
Cannot be computed if
market prices are
unavailable
Quantifies overall risk of
bond relative to Treasury
benchmark but cannot
be used to isolate
particular risk types
Z-Spread Quantifies risk as implied Does not accommodate
by the market any embedded options
Cannot be computed if
market prices are
Constant spread is unavailable
added to each spot rate,
so bonds with different Quantifies overall risk of
coupons can be bond relative to Treasury
compared benchmark but cannot
be used to isolate
particular risk types
Option-Adjusted Spread Quantifies risk as implied Dependent on the
(OAS) by the market interest rate model used
and the volatility
Constant spread is estimates
added to each spot rate,
so bonds with different Cannot be computed if
coupons can be market prices are
compared unavailable
Is able to accommodate Quantifies overall risk of
embedded options bond relative to Treasury
benchmark but cannot
be used to isolate
particular risk types
Nominal spreads are commonly used because of their simplicity and ease of computation. Traders will often
compare comparable securities by discussing their relative nominal spreads. For more precise valuation, even when
dealing with bullet bonds, Z-spreads are technically superior.

For option-free bonds, market participants will use both nominal and Z-spreads. We have discussed why Z- spreads
are a more precise measure of spread across the entire curve, but nominal spreads are a common and easy first
step.

For bonds where options are present, market participants will look at all three spread measures discussed, but
spend more time refining their analysis of OAS. The main advantage of OAS analysis for option- embedded bonds, is
that it allows comparison across different bond structures on a risk-adjusted basis.

Theoretically, one could compare the OAS on a mortgage or asset-backed security to a non-callable corporate bond
and make some relative value judgements. In practice, portfolio managers tend to use OAS models within sectors of
the market to gauge relative value.

10. Question

a. Which of the following is a true statement? Corporate bond option-adjusted spreads (OAS) cannot be negative
because they .... OAS reflect the credit risk, liquidity risk, and option risk of corporate bonds. All three sources of risk
are larger for corporate bonds than for Treasury bonds. Hence, OAS are always positive.

b. Suppose we have the same scenario as earlier, that is

However, now the volatility term structure shifts up by one percentage point. How is the option-adjusted spread
(OAS) affected and why? The OAS ...

As the interest rate volatility increases, the value of the embedded option increases. Hence, the embedded option
becomes more valuable to the bond issuer, and correspondingly, the option cost to the bondholder increases. Since
the OAS can be computed as OAS = Z-spread − option cost, the OAS has to decrease. We have ΔOAS = ΔZ-spread –
Δoption cost = 0 bp – (18.10 bp – 13.85 bp) = – 4.25 bp.

c. Suppose you use the original scenario from Question 2, how is the difference between the Z-spread and the
nominal yield spread for the option-free bond affected when we switch from spot rates to par yields? Why does the
difference change in this way?

The difference between the Z-spread and the nominal yield spread ...

As we saw in Module 1, par yields are averages of different spot rates because they are a one-value summary
measure of a bond’s yield. Therefore, the par curve is the flattest of all yield curves and the steepness of the
resulting spot rate curve increases. As we have seen earlier, the steeper the spot rate curve, the larger the
difference between the nominal spread and the Z-spread is going to be. The two measures will be the same if the
spot rate curve is flat.
d. For the original scenario from Question 2, increase the callability start date from 2 years to 5 years from now and

then press: How does the option -adjusted spread (OAS) change? The OAS ... We know that
a later callability start date and thus a shorter life will make the call option less valuable to the issuer. Therefore, the
option cost to the bondholder will decrease. Since ΔOAS = ΔZ-spread – Δoption cost, the OAS has to increase due to
the lower option cost. From the spreadsheet we have ΔOAS = OASnew – OASold = 175.29 bps – 166.02 bps = 9.27
bps

The OAS will increase when the call date moves further into the future. A later call date reduces the value of the call
option to the issuer, which increases the bond value to the investor.

e. Which of the following is the best explanation for why mortgage-backed securities (MBS) are more difficult to
value using option-adjusted spreads (OAS) than standard callable corporate bonds? MBS are more difficult to value
because ... the decision to prepay is a lot more idiosyncratic than a corporate bond issuer’s decision to call the bond,
which is almost exclusively determined by interest rate factors.

A prepayment on an MBS is not necessarily more likely than a call on a corporate bond. The likelihood depends on
the particular security characteristics and interest rate scenario.