Option-Adjusted Spread

OPTION-ADJUSTED SPREAD

• An Option-Adjusted Spread (OAS) is a fixed-income metric that measures the yield spread of a bond relative to a risk-free benchmark, adjusted for the impact of embedded options. 

• Unlike traditional spread measures, OAS accounts for the uncertainty created by options such as calls, puts, or prepayment features, making it a more accurate way to assess bond valuation and risk-adjusted returns.

• A wider OAS indicates that investors are being compensated more for taking on risk (potential undervaluation), while a narrower OAS suggests less compensation (potential overvaluation). 

• OAS is most commonly applied in analyzing mortgage-backed securities (MBS), callable corporate bonds, and other fixed-income securities with complex or uncertain cash flows.

HOW OAS WORKS

• Compare to Treasuries 

Start with the bond’s yield versus the Treasury yield curve (the risk-free benchmark).

• Model Cash Flows 

For plain vanilla bonds, cash flows are fixed. For callable, puttable, or MBS bonds, cash flows vary with interest rates and option exercise.

• Simulate Scenarios 

Use tools like binomial interest rate trees or Monte Carlo simulations to model interest rate paths and cash flow timing.

• Strip Out Options 

Adjust the spread by removing the effect of embedded options, isolating the “pure spread” the bond offers over Treasuries.

WHY OAS MATTERS

• True Relative Value 

Unlike nominal or Z-spreads, OAS accounts for embedded options, enabling fair comparison across callable vs. non-callable bonds.

• Risk Assessment 

Higher OAS values compensate investors for risks like credit, liquidity, and structure; extremely high OAS may signal market stress or default risk.

• Mortgage-Backed Securities (MBS) 

Since homeowners can prepay, MBS cash flows are uncertain. OAS modeling helps investors judge their real attractiveness.

• Callable Bonds 

OAS evaluates whether a bond’s yield is adequate once call risk (issuer refinancing when rates fall) is properly factored in.