Fixed Income Investments - Differentiating Between Spreads

The nominal spread is simply the difference in basis points between the Treasury and non-treasury security. For example, if the Stone & Co. bonds have a yield of 5.5% and the comparable Treasury security has a yield of 4.5% the nominal spread is 100 bps. (5.5% - 4.5%).

  • Zero-Volatility Spread or Z-spread
    This measures the spread the investor would capture over the entire Treasury spot- rate curve if the bond was held to maturity. The Z-spread is calculated as the spread that will make the present value of cash flows from the non-treasury security when they are discounted at the Treasury spot rates plus the Z-spread equal to the non-Treasury securities price. This is done by trial and error. This is different than the nominal spread because the nominal spread just uses one point on the curve.

    For example, take the spot curve and add 50 basis points to each rate on the curve. If the two year spot rate is 3%, the rate you would use to find the present value of that cash flow would be 3.50%. After you have calculated all of the present values for the cash flows, add them up and see whether they equal the bonds price. If they do, then you have found the Z-spread, if not, you have to go back to the drawing board and use a new spread until the present value of those cash flows equals the bonds price.

  • Option-Adjusted Spread (OAS)
    This takes the dollar difference between the fair price and the market price and converts it into a yield measure. The OAS helps reconcile the value to market price by finding a spread that will equate the two. This is also done on a trial-and-error basis and is very model dependent.
  1. Interest rate volatility is critical. The higher the volatility, the lower the OAS. Check this assumption when making comparisons.
  2. The OAS is a spread over the Treasury spot-rate curve or benchmark that is used in the analysis.
  3. As the name implies, the security's embedded option can change the cash flows and the value of the security should take this change in account. The difference between the OAS And the Z-spread is that the Z-spread doesn't take this into consideration.
  • Option Cost
    This cost can be derived by calculating the difference between the OAS at the assumed interest rate or yield volatile and the Z-spread.
    Z-spread = OAS + option cost
    Option Cost = Z-spread - OAS
    The option cost is measured in this way because if rates do not change, the investor would earn the Z-spread. When future rates are uncertain, the speed tends to be different because of the embedded option. The option cost for a callable bond and most MBS and ABS securities are positive. This is because the issuer's ability to alter the bond's cash flows will result in an OAS that is less than the Z-spread. For puttable bonds the option cost is negative because of the investor's ability to alter the cash flows.
What are Forward Rates?
Related Articles
  1. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  2. Investing

    Asset Manager Ethics: Investment Process and Actions

    Managers, in developing their investment process, need to determine some “general rules” that make it meaningful. We offer six.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Advisors: Which Certifications Are Essential?

    The right advisor credentials can make all the difference, but wading through some 100 certifications can be a challenge. Here's some help.
  5. Investing Basics

    Asset Manager Ethics: Valuation Is A Tricky Business

    Asset managers must accurately represent all of a clients assets in the client portfolio. This can be tricky for unique and hard-to-value assets.
  6. Personal Finance

    Top 10 Most Valuable Sports Teams in 2015

    Cleats, pads and profits: we take a look at the top 10 most valuable sports teams in the world.
  7. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  8. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  9. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  10. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!