OAS versus nominal spread

For bonds with embedded options (e.g. call options, prepayments, embedded rate
caps, and so on), the difference between the option-adjusted spread and nominal
spread (the difference between the bond’s yield-to-maturity or yield-to-call and the
yield on a specific Treasury) can be substantial. Compared to nominal spread, OAS
is a superior measure of a security’s risk premium for a number of reasons:
Ω OAS analysis incorporates the potential variation in the present value of a bond’s
expected future cash flows due to option exercise or changes in prepayment
speeds. Nominal spread is based on a single cash flow forecast and therefore
cannot accommodate the impact of interest rate uncertainty on expected future
cash flows.
Ω OAS is measured relative to the entire spot curve, whereas nominal spread is
measured relative to a single point on the Treasury curve. Even for option-free
securities, this is a misleading indication of expected return relative to a portfolio
of risk-free Treasuries offering the same cash flows, particularly in a steep yield
curve environment.
Ω Nominal spread is a comparison to a single average life-matched Treasury, but if
a security’s average life is uncertain its nominal spread can change dramatically
(especially if the yield curve is steeply sloped) if a small change in the Treasury
curve causes the bond to ‘cross over’ and trade to its final maturity date instead of a call date, or vice versa. OAS is computed relative to the entire set of Treasury
spot rates and uses expected cash flows which may fluctuate as interest rates
change, thus taking into account the fact that a security’s average life can change
when interest rates shift and a call option is exercised or prepayments speed up
or slow down.
Ω Nominal spread assumes all cash flows are discounted at a single yield, which
ultimately implies that cash flows from different risk-free securities which are
paid in the same period (e.g. Year 1 or Year 2) will be discounted at different rates,
simply because the securities have different final maturities, and so on.
Although OAS is clearly superior to nominal spread in determining relative value,
there are a number of problems associated with using OAS. For example, OAS
calculations can vary from one model to another due to differences in volatility
parameters, prepayment forecasts, etc. Nonetheless, OAS is now a commonly
accepted valuation tool, particularly when comparing the relative value of fixedincome
securities across different markets.