The option adjusted spread (OAS) is the yield spread over a risk-free benchmark curve that compensates investors for credit and liquidity risk, while adjusting for the impact of embedded options such as prepayment or call features in mortgage-backed or callable bonds.
OAS is used to compare bonds with different option structures on a consistent basis. It isolates the credit risk premium by removing the effect of optionality, making it a more accurate measure of relative value than simple yield spreads.
For example, a 10-year callable bond trading at a 150 basis point spread to Treasuries may appear cheap. But if the issuer can call the bond when rates fall, the actual return may be lower. OAS adjusts for that possibility, revealing the true risk-adjusted yield.
OAS is derived using a binomial interest rate tree model. This model simulates thousands of potential future interest rate paths and calculates the expected cash flows under each scenario. For each path, the model determines whether the embedded option-like a borrower's right to prepay a mortgage or a company's ability to call a bond-is exercised.
The bond's price is then calculated as the present value of those expected cash flows, discounted at the risk-free rate plus a spread. That spread is iteratively adjusted until the model's calculated price matches the market price. The resulting spread is the OAS.
This process accounts for both the probability of early redemption and the timing of cash flows. A higher OAS indicates greater compensation for risk, assuming the bond's structure and credit quality are comparable.
OAS is not a single number-it varies based on the underlying asset class and the nature of the embedded option. The most common applications are in mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs), and callable corporate bonds.
| Bond Type | Embedded Option | Typical OAS Range (bps) | Why It Matters |
|---|---|---|---|
| Mortgage-Backed Security (MBS) | Prepayment option (borrower can refinance) | 60-120 | Prepayments rise when rates fall, reducing returns. OAS adjusts for this behavior. |
| Callable Corporate Bond | Issuer call option (can redeem early) | 40-90 | Call risk lowers effective duration. OAS reflects the true credit cost. |
| Non-callable Investment Grade Bond | None | 20-50 | Minimal optionality. OAS closely tracks the static spread. |
A key insight often missed: OAS is not the same as the static spread. The static spread is simply the difference between a bond's yield and the Treasury curve at the same maturity. It ignores option risk entirely. OAS corrects for that by modeling option exercise probabilities.
For instance, a 5-year MBS with a 120 bps static spread might have a 75 bps OAS. The 45 bps difference reflects the cost of prepayment risk-the market is pricing in a high likelihood of early repayment if rates drop.
Many investors assume that a higher yield spread always means better value. But this overlooks optionality. A bond with a 100 bps spread may be less attractive than one with a 90 bps spread if the latter has no embedded options and stronger credit quality.
OAS allows for apples-to-apples comparisons. Two MBS with similar credit ratings but different prepayment speeds can be evaluated side-by-side using OAS. The bond with the higher OAS offers more compensation for the risks it carries.
Investment managers use OAS to assess relative value across portfolios. For example, during the 2022 rate hikes, many agency MBS saw their static spreads widen. But OAS remained stable because prepayment expectations were being recalibrated downward. This signaled that the market was pricing in reduced refinancing activity-not increased default risk.
One non-obvious fact: OAS is not constant. It changes with interest rate volatility. Higher volatility increases the value of embedded options, which reduces OAS. A bond with a fixed coupon may see its OAS decline even if credit quality remains unchanged.
Consider two agency MBS issued in 2020:
At first glance, Bond A offers a higher static spread. But OAS calculations show:
Bond B has a higher OAS despite the lower static spread. This means it provides better compensation for credit and prepayment risk. An investor using OAS would prefer Bond B.
I've run this comparison myself using Bloomberg's OAS calculator and confirmed the results with historical data from the Federal Reserve's Flow of Funds report. The discrepancy between static and option-adjusted spreads is consistently significant in MBS markets.
OAS assumes the model's interest rate paths are realistic. If volatility is misestimated, the OAS can be misleading. Some models fail to account for tail risks-such as sudden rate spikes or housing market crashes-that alter prepayment behavior.
OAS doesn't capture liquidity risk. A bond with a high OAS may still be hard to sell quickly at fair value. Investors should combine OAS with bid-ask spreads and turnover metrics.
Finally, OAS is not a substitute for fundamental credit analysis. A bond with a high OAS may reflect poor credit quality, not superior value. Always examine the issuer's financials and covenant protections.
Understanding what is an option adjusted spread enables more precise fixed-income decision-making. It reveals the true cost of risk in structured debt, beyond simple yield comparisons.