I always confuse here. Manager purchase two callable bonds with similar credit and maturity. Which of two bonds is most likely to be called and the answer is: the bond with lower OAS.
Other options are z-spread and I-spread. I know they are incorrect because embedded option. But trying to understand why Lower OAS is more likely to be called compared to higher OAS.
Higher volatilty of interest rates means lower OAS, and higher volatility stands for higher possibility of callability.
There are plenty of past questions on OAS, you can find better answers than mine 
The volatility of interest rates should be the same for both bonds.
Can you post the full question
Thank you.
It is example 7 in 2022 reading 14. An active manager is weighing purchase of two callable bonds with similar credit risk and same final maturity. Which of the two bonds is more likely to be called on the next call date?
A. Bond with lower ASW
B. Bond with lower z-spread
C. Bond with lower OAS.
No idea was A is; B wrong spread so by process of elimination it’s C
I haven’t the 2022 curriculum yet, so I cannot say what it says about this. I’ll look into it after the November exams.
Thank you S2000.
I get by process of elimination but Iike to understand why. That is entire question though.
I got that.
What I meant is that the curriculum might shed some light on their conclusion.
No problem. Understand thats lots of little things. Thank you
I’m confused about this one too…
OAS can be viewed as the added yield required to adjust the price of a fixed income security with embedded option to make it comparable with another (option free) bond. If you have a high probability of a a fixed income being called by the issuer then the yield of this called bond will be LOWER then the yield of a comparable option free bond, ceteris paribus.
Another way to understand why a callable bond would have a relative lower OAS is to consider the OAS like a « premium » you would add to adjust the discount rate applied to price your callable bond.
If you are the investor you must be compensated for a LOWER yield because your bond will be redeemed sooner. Hence, the price of the callable bond must be higher and the discount rate LOWER (lower OAS).
Hope this helps.
A callable bond with a lower price is most likely to be called (call option would be increasing in value at low rates)
callable bond = straight bond - call option
as the call option rises in value, the callable bond starts dropping in value, which lowers the OAS (the spread needed to remove the call option from the bond)
At low rates (yields), bonds have high prices, not low prices.
Let’s rethink this one.
Remember the curve between bond price and yield!
Lower OAS means lower yield and that means higher bond price. And, if there is a parallel level change (decrease) in interest rate in the market, price of lower OAS bond will go up higher than the price of higher OAS bond because of the curve shape. It means that lower OAS bond will become ‘in the money’ sooner than higher OAS bond. Hence, lower OAS bond will be called by the owner of the call option.
Yield on a bond = spot rate + z (simplified version)
z = OAS + Option cost
Option cost is a positive number for callable bond and negative number for a putable bond.
OAS = credit risk + liquidity risk
In the example, maturity and credit risks are same. It means spot rate as well as credit risk are same. It looks like the difference in OAS is coming from liquidity.
Most likely higher OAS bond is getting liquidity premium compared to lower OAS bond.
Just went through the same topic and question. This concept took me a while to make sense.
Here’s my five cents, Hope the price is right.
OAS = Z-Spread - Option Cost
Spot rate + OAS = discount rate for the callable bond (d)
When option value (option cost) is high for callable bond, OAS will get compressed (ie. low).
When OAS is lower, the discount rate (d) will also be lower. Hence, discounting the cashflows of callable bond with lower discount rate of the callable bond (d), we get higher value for the option-free bond.
Now notice 2 things in the aforementioned that lead to the answer:
Higher option value produces lower OAS. That means the call option is nearer to the money and has higher value (so more likely to called by the bondholder).
Lower OAS produces higher value option-free bond. That means the difference in value between option-free bond & callable bond will be larger - usually the case with callable bond nearing call date near or in the money (so more likely to called by the bondholder)?
Also notice if the option cost is 0 (no value) as is the case with option-free bond, Z-spread = OAS and the price of the callable bond = option-free bond.
You can get the answer using point 1. I just thought point 2 may help further illustrate.