r bond equiv. yield = 2[(1 + i monthly)6 – 1]
An investor actually realizing the cash flow yield return depends upon the following taking place:
- Cash flows are re-invested every month at the cash flow yield;
- Prepayments equal the assumed prepayment schedule;
- The investor holds the ABS/MBS until it is retired.
Nominal Spread
Compares the cash flow yield of the ABS/MBS to the yield to maturity of a Treasury security with a maturity equal to the average life of the ABS/MBS.
Nominal Spread = CF Yield – YTM of comparable Treasury
The nominal spread may be a flawed measure of comparison as the spread may not reflect risk premiums unique to the ABS/MBS, such as prepayment risk.
Zero-Volatility Spread (aka Z-spread or static spread)
The Z-spread is the spread that an ABS/MBS investor will receive over the complete Treasury spot rate curve, if the security is held to maturity.
The Z-spread will be closer to the nominal spread when: the ABS/MBS has a short average life and/or when the yield curve is relatively flat.
The Z-spread assumes that the timing and amount of principal payments are known, regardless of future interest rate path changes. In other words, the Z-spread assumes interest rates are constant, so prepayments are known.
Given the material prepayment risk inherent in ABS/MBS, the Z-spread may not be appropriate for relative valuation analysis.
Option Adjusted Spread (OAS)
Since the OAS adjusts for option risk, it is a good measure of relative risk after adjusting for the impact of prepayments.
