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Option-Adjusted Spread (OAS) is an important measure of total bond return and a useful tool for risk analysis. It is a measure of the yield difference between an option-bearing debt instrument and a comparable option-free investment security. The OAS is expressed as the spread over or basis points/percentage below a benchmark yield curve, such as the zero-coupon treasury curve. OAS is used to capture the effects of embedded options, such as callable bonds or mortgage-backed securities, on the price of the bond.
Since security values fluctuate with interest rate and volatility conditions, using OAS will help investors assess relative value and risk-adjusted returns between different option-bearing securities. OAS reflects the market’s implied expectations of an instrument’s return performance over time. Specifically, the spread between the option-adjusted security yield and the Treasury yield reflects a compensation for the higher volatility of the option-bearing security compared with the more stable, option-free securities.
Because of the presence of embedded options, calculating the OAS for a security is not as straightforward as calculating the yield for an option-free investment such as a Treasury security. Bloomberg calculates the internal rate of return (IRR) for a security and compare it to a benchmark in order to calculate the OAS. The OAS calculation will show the magnitude of any reductions in the intrinsic value of the security due to embedded optionality.
Option-Adjusted Spreads are used by issuers and investors to price callable bonds, and are increasingly being included in the pricing of mortgage-backed securities. Treasury yields provide a risk-free benchmark rate against which to discount or compare other securities and determine their relative value. The difference between the OAS and the Treasury yield reflects not just the interest rate and credit risk but also the value of embedded options. Investors should account for this additional factor when determining what is an acceptable yield for a particular security. By taking the OAS into consideration, investors can more accurately calculate the risk-adjusted return for various securities, allowing for a better comparison between investments.
Since security values fluctuate with interest rate and volatility conditions, using OAS will help investors assess relative value and risk-adjusted returns between different option-bearing securities. OAS reflects the market’s implied expectations of an instrument’s return performance over time. Specifically, the spread between the option-adjusted security yield and the Treasury yield reflects a compensation for the higher volatility of the option-bearing security compared with the more stable, option-free securities.
Because of the presence of embedded options, calculating the OAS for a security is not as straightforward as calculating the yield for an option-free investment such as a Treasury security. Bloomberg calculates the internal rate of return (IRR) for a security and compare it to a benchmark in order to calculate the OAS. The OAS calculation will show the magnitude of any reductions in the intrinsic value of the security due to embedded optionality.
Option-Adjusted Spreads are used by issuers and investors to price callable bonds, and are increasingly being included in the pricing of mortgage-backed securities. Treasury yields provide a risk-free benchmark rate against which to discount or compare other securities and determine their relative value. The difference between the OAS and the Treasury yield reflects not just the interest rate and credit risk but also the value of embedded options. Investors should account for this additional factor when determining what is an acceptable yield for a particular security. By taking the OAS into consideration, investors can more accurately calculate the risk-adjusted return for various securities, allowing for a better comparison between investments.