Learning Outcomes
After studying this article, you will be able to define credit spreads, describe their relationship to default risk, liquidity, and maturity, and explain how credit spreads vary across the yield curve. You will also understand the concept of option-adjusted spread (OAS), its use in evaluating bond pricing with embedded options, and the distinction between nominal and OAS spreads. By the end, you will confidently apply these concepts to fixed income analysis for the CFA Level 1 exam.
CFA Level 1 Syllabus
For CFA Level 1, you are required to understand credit spreads and OAS as key components of fixed income valuation. This article covers the core syllabus points relevant for the exam:
- Explain what a credit spread is, what it measures, and why it changes.
- Relate the term structure of credit spreads to bond maturity, default risk, and liquidity.
- Define and interpret option-adjusted spread (OAS) and explain its relevance for bonds with embedded options.
- Calculate and interpret the relationship between nominal spread, OAS, and option cost.
- Assess how credit spreads affect bond yields and price different types of fixed income securities.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What does a widening credit spread generally indicate about market perceptions of risk for a corporate bond issuer?
- How does the option-adjusted spread (OAS) aid analysis of callable or putable bonds compared to the nominal (quoted) spread?
- If two bonds have the same credit rating but one has a higher credit spread, what might this imply about their relative liquidity?
Introduction
Credit spreads and option-adjusted spreads are critical inputs for valuation and risk assessment of fixed income securities. Understanding how spreads quantify differences in credit risk and liquidity, as well as how embedded options affect yield calculations, is essential for accurate bond valuation, especially when comparing corporate, government, and structured bonds. Thorough understanding of these concepts helps CFA candidates interpret market signals and compare relative value across the term structure.
Key Term: credit spread
The yield difference between a non-government (risky) bond and a comparable-maturity benchmark risk-free bond, typically used to quantify credit risk and liquidity differences.Key Term: term structure of credit spreads
The pattern of credit spreads across different maturities, often reflecting changes in default risk, liquidity, or risk premiums as the time horizon extends.Key Term: option-adjusted spread (OAS)
The spread over the benchmark yield curve that accounts for the expected value of any embedded options in a bond, making it useful for comparing bonds with and without options.
Credit Spreads: Definition and Key Drivers
A credit spread reflects the additional yield investors demand for holding a bond with credit risk or reduced liquidity compared to a government (risk-free) bond. The quoted spread is measured in basis points (bps).
Key factors that influence credit spreads include:
- Default risk: Higher probability of default requires more compensation, resulting in a wider spread.
- Liquidity: Less liquid bonds typically have wider spreads, even if they have the same credit rating.
- Maturity: Spread levels usually change with maturity, termed the term structure of credit spreads.
- Market sentiment: Widening credit spreads may signal rising risk aversion or concern over macroeconomic conditions.
Key Term: default risk premium
The portion of the credit spread compensating investors for the probability and potential loss given default of the issuer.
The Term Structure of Credit Spreads
The term structure of credit spreads refers to how credit spreads vary depending on the maturity of a bond. In practice, the credit spread is usually lowest for the shortest maturity and increases for intermediate maturities, potentially flattening or even narrowing for very long maturities.
Several factors influence the shape of the term structure:
- Default risk often rises as maturity increases, widening spreads.
- Uncertainty over the issuer’s financial strength or economic cycle can cause spreads to steepen for longer maturities.
- Lower market liquidity for long-dated or very short-dated bonds can flatten or distort the spread term structure.
Worked Example 1.1
Question:
A 2-year BBB-rated corporate bond has a spread of 70 bps over the risk-free yield. The 10-year BBB-rated bond from the same issuer trades at a spread of 120 bps. What does this shape of the term structure suggest about investor perceptions?
Answer:
The upward slope suggests investors expect higher uncertainty or default risk for the issuer as time extends, or they demand additional compensation for greater exposure to long-term risks. If economic or issuer conditions are stable, the spread curve may be flatter.
Option-Adjusted Spread (OAS): Basics
For bonds with embedded options (e.g., callable, putable, or mortgage-backed securities), the quoted nominal spread reflects both credit risk and the value of any options. The OAS is used to separate the option value and provide a consistent basis for yield comparison.
OAS is calculated by removing the value of the embedded option from the nominal spread. For callable bonds, the option cost is subtracted from the nominal spread; for putable bonds, it is added.
Key Term: nominal spread
The quoted spread between a bond’s yield and the yield of a comparable government bond, before adjusting for embedded options.Key Term: option cost
The estimated value of the embedded option, generally measured in yield terms.
Worked Example 1.2
Question:
A callable bond has a nominal spread of 200 bps over the benchmark. The estimated value of the embedded call option is 40 bps. What is the OAS?
Answer:
OAS = Nominal spread – Option cost = 200 bps – 40 bps = 160 bps. This OAS should be compared to non-callable bonds as it excludes the yield impact of issuer call rights.
Exam Warning
A common mistake is to compare nominal spreads for bonds with different option features. For accurate comparison, use the OAS, which excludes embedded option values.
Credit Spread Analysis in Practice
Credit spreads and OAS are applied in different contexts for bond analysis:
- Comparing credit quality: A sudden increase in spreads may indicate perceived deterioration in creditworthiness or liquidity.
- Identifying relative value: Two bonds with similar ratings but different spreads may differ in liquidity or option features.
- Pricing new issues: Underwriters set the initial spread to reflect current market conditions and issuer risk.
- Monitoring term structure: Portfolio managers use the spread curve to position portfolios in response to spread changes over time.
Worked Example 1.3
Question:
Bond A (non-callable) and Bond B (callable) both have AA ratings and 7-year maturities. Bond A yields 3.2%, the benchmark yield is 2.5%, and Bond B yields 3.5% with an estimated option cost of 0.3%. What are the credit spreads and OAS, and which has higher true credit compensation?
Answer:
Bond A: Credit spread = 3.2% – 2.5% = 0.7% (70 bps);
Bond B: Nominal spread = 3.5% – 2.5% = 1.0% (100 bps);
Bond B OAS = 100 bps – 30 bps = 70 bps.
Adjusted for option value, both have the same OAS, so both offer equal credit compensation.
Revision Tip
When interpreting OAS, always check whether the option-adjusted spread truly reflects the compensation for credit and liquidity, not embedded call or put value.
Summary
Credit spreads represent the extra yield investors require for bearing credit and liquidity risk. The term structure of credit spreads informs about changing risk over different maturities. The option-adjusted spread (OAS) refines spread analysis for bonds with embedded options by stripping out the option’s value, yielding a consistent measure for comparison. Accurate application of these concepts underpins robust bond selection and risk management.
Key Point Checklist
This article has covered the following key knowledge points:
- Explain what a credit spread is and what factors drive its level.
- Describe how the term structure of credit spreads changes and the reasons for changes in slope.
- Define option-adjusted spread (OAS), differentiate it from nominal spread, and explain its use for bonds with embedded options.
- Calculate OAS and interpret its meaning in bond comparison.
- Recognize the analytical significance of changes in credit spreads for market and issuer risk assessment.
Key Terms and Concepts
- credit spread
- term structure of credit spreads
- option-adjusted spread (OAS)
- nominal spread
- option cost
- default risk premium