Lower credit quality and higher OAS

CFA Level III
#1

Can someone enlighten me on why buying low credit quality means higher OAS.

Higher OAS is associated with putale bonds

#2

Higher OAS is associated with bonds for which the investing public demands a higher yield: spread = yield.

#3

But doesn’t putable have lower yield? OAS in effect removes the effect of optionality. Is it not the reason OAS is greater than z spread for putable bonds?

Unless you mean higher yield in context of after removing the effect of optionality.

Please correct my understanding.

Thanks

#4

Lower than an otherwise identical, option-free bond? Yes.

Exactly. Which means that if you have three fairly priced bonds, one option-free, one callable, one putable, but in all other respects identical, they will have the same OAS; in effect, the OAS turns them all into option-free bonds.

Exactly. And that’s what the OAS tells us.

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#5

But what is the relationship between OAS and credit quality? Is it only higher yield?

#6

OAS is a spread over the risk-free rate: additional yield for accepting additional risk. Lower quality bonds have higher spreads; higher quality bonds have lower spreads.

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#7

Thank You.

#8

My pleasure.