An analyst makes the following spread estimates relative to US treasuries for a callable corporate bond:
-Nominal spread realtive to t-yield curve: 240 basis points
Z-spread relative to reasury spot curve: 225 basis points
OAS relative to the Treasury spot curve: 190 basis points
The analyst also determined that the Z-spread over treasuries on comprable option-free bonds (i.e., bonds wiht the same credit ratings, maturity, and liquidity) in the market is 210 basis points. Determine whether the bond is voervaleud, undervalued or properly valued.
Can someone please help go through their methods and how they think through this question?
They give you two Z-spreads… what are the differneces between the two? This bond that we are estimating also is a callable corporate bond… which has an option…
Thanks a ton, and good luck studying today everyone.
Dear, the second Z spread U should use it to make the comparsion with OAS, Since first Z spread compensate U for liquidity risk, Credit risk & Option risk, while OAS compensate U for liquidity risk, Credit risk,
So in order to do apple to apple comparsion You should use OAS and the second Z spread wich is equall to OAS, since it’s based on option free bond so Now;
OAS compensate U for liquidity risk, Credit risk second Z spread compensate U for liquidity risk, Credit risk.
U can make your relative analysis;
OAS<210, so the callable corporate bond is over prices & U should sell it. Good luck.
Recall that a bond’s OAS is the spread with the value of any embedded options removed; i.e., the OAS is the spread for an equivalent, _ but option-free _, bond.
Thus, if you’re going to compare the OAS to a Z-spread, you have to compare it to the Z-spread for a comparable, _ option-free bond _. (For an option-free bond, the Z-spread and the OAS are equal.)
Here, the OAS is 190bp, while the Z-spread (OAS) for comparable, option-free bonds is 210bp. Thus, our bond is overpriced.