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Option-Adjusted Spread: Formula & Examples

Instructor: Roderick Powell

Roderick has taught college Economics and has a master's degree in business.

This lesson defines the option-adjusted spread and explains how the metric is used by bond investors to make decisions. You'll also learn the components of the option-adjusted spread and how the metric is calculated.

Comparing Apples to Oranges

Most of you have heard the phrase don't compare apples to oranges. In the world of bond investments, the first attempts at comparing the potential return of mortgage-backed securities to more traditional bonds, such as corporate bonds, was a case of comparing apples to oranges. Mortgage-backed securities (MBS) are bonds derived from residential mortgages. Mortgages contained embedded prepayment options. In other words, borrowers have the option, if they choose, to pay off the balance of their mortgages early without penalty.

The majority of corporate bonds, i.e., bonds issued by corporations, do not contain the same embedded prepayment options as mortgage-backed securities. Therefore, comparing mortgage-backed securities and corporate bonds is like comparing apples to oranges. The option-adjusted spread was created to give investors a way to put these securities on a level playing field, i.e., make them apples to apples, in order to determine which type of investment offered the best value for the money.

Traditional Credit Spread vs. Option-Adjusted Spread

Corporate bonds are usually quoted at some spread over the rate of U.S. Treasury securities. U.S. Treasury securities are bonds issued by the U.S. government. For example, the coupon rate of a corporate bond is compared to the coupon rate of a U.S. Treasury security with the same maturity date. The difference is the amount of return a corporate bond investor can expect to receive above that of a comparable maturity Treasury bond.

The difference in the rate between a corporate bond and a Treasury bond is primarily due to credit risk, i.e., the risk that the issuer of the corporate bond will default on its' obligation. It is usually assumed that U.S. Treasury securities are default-free since they are issued by the U.S. government. If the coupon rate of a 10-year corporate bond is 4%, and the coupon rate of a 10-year Treasury bond is 2%, then the credit spread is 2%.

Because mortgage-backed securities include an embedded option, the rate of these bonds is higher than that of Treasury bonds due mainly to compensation given to the investor for holding a bond that can be called away at any time. Therefore, the difference between the rate of an MBS and the rate of a Treasury bond does not represent pure credit risk. If you are an investor deciding between buying a corporate bond or an MBS and you want to know which bond type offers the greatest potential return due to credit risk over a Treasury security, you cannot use the traditional credit spread approach.

The option-adjusted spread, also known as an OAS, is a spread that is adjusted for the fact that an MBS includes an embedded option. If you compare the option-adjusted spread of an MBS with the credit spread of a corporate bond, then you are comparing potential return metrics on an apples to apples basis. For example, suppose an MBS with an average life of five years has an OAS of 10 basis points and a corporate bond maturing in five years has a credit spread of 20 basis points. This means that the corporate bond will be selling at a lower price than the MBS and has the potential to earn a higher return over Treasuries than the MBS.

Investors also use the OAS to compare one MBS to another MBS to decide which is the better potential investment. For example, for two MBS with the same estimated maturity, the one with the higher OAS will be selling at a lower price and may be considered a bargain compared to the alternative MBS.

Composition of the Option-Adjusted Spread

The majority of MBS that are traded in the marketplace are what are known as agency MBS. They are backed or issued by an agency of the U.S. government and are therefore assumed to be default-free. In the case of agency MBS, only a minute amount of the OAS reflects credit or default risk. The majority of the OAS reflects the liquidity risk and prepayment modeling uncertainty assumed by the investor of an MBS.

Investors cannot be sure to what extent borrowers will prepay their mortgages early and they must make educated guesses. The uncertainty of these guesses is reflected in the OAS. The investor must be compensated for this modeling uncertainty. In addition, agency MBS are a little less liquid than Treasuries so investors must also be compensated for liquidity risk. It should be noted that corporate bond spreads to Treasuries also reflect liquidity risk.

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