Reading 24 - EOC problem 12, bottoms up approach

[NeverQuit]

Which of the following comments is most likely correct. Answer - comment 3. I agree that is a correct answer. However, it seems to me comment 1 is also correct. Callable debt should have a smaller OAS than non-callable debt.

OAS = Z spread - option cost. since callable debt has positive option cost, it would follow that the OAS would be smaller than comparable non-callable debt. What am I missing?

1. Comment 1 - Callable debt has a smaller option-adjusted spread than comparable non-callable debt.
2. Comment 2 Benchmark corporate bond issues normally have wider spreads than older bonds of the same issuer.
3. Comment 3 The announcement of a new corporate bond issue often leads to an increase in the credit spread on the existing bonds.

[S2000magician]

@NeverQuit

Which of the following comments is most likely correct. Answer - comment 3. I agree that is a correct answer. However, it seems to me comment 1 is also correct. Callable debt should have a smaller OAS than non-callable debt.

OAS = Z spread - option cost. since callable debt has positive option cost, it would follow that the OAS would be smaller than comparable non-callable debt. What am I missing?

You’re missing the fact that OAS removes the optionality, resulting in a spread for the underlying, option-free bond; the OAS should be the same for a callable bond and an otherwise identical non-callable bond.