What is the ‘Option-Adjusted Spread (OAS)’
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.
BREAKING DOWN ‘Option-Adjusted Spread (OAS)’
The option-adjusted spread helps investors compare a fixed-income security’s cash flows to reference rates while also valuing embedded options against general market volatility. By separately analyzing the security into a bond and the embedded option, analysts can determine whether the investment is worthwhile at a given price. The OAS method is more accurate than simply comparing a bond’s yield to maturity to a benchmark.
Options and Volatility
A bond’s yield to maturity (YTM) is the yield on a benchmark security, which can be a Treasury security with a similar maturity plus a premium or spread above the risk-free rate to compensate investors for the added risk.
The analysis gets more complicated when a bond has embedded options. These are call options, which give the issuer the right to redeem the bond prior to maturity at a preset price, and put options that allow the holder to sell the bond back to the company on certain dates. The OAS adjusts the spread in order to account for the potential changing cash flows.
The OAS takes into account two types of volatility facing fixed-income investments with embedded options: changing interest rates, which affect all bonds, and prepayment risk. The shortfall of this approach is that estimates are based on historical data but are used in a forward-looking model. For example, prepayment is typically estimated from historical data and does not take into account economic shifts or other changes that might occur in the future.
The OAS should not be confused with a Z-spread. The Z-spread is the constant spread that makes the bond’s price equal to the present value of its cash flow along each point along the Treasury curve. However, it does not include the value of the embedded options, which can have a big impact on the present value.
OAS is particularly useful in the valuation of mortgage-backed securities. In this sense, the prepayment risk is the risk that the property owner may pay back the value of the mortgage before it is due. This risk increases as interest rates fall. A larger OAS implies a greater return for greater risks.