Choosing an Appropriate Spread for ABS/MBS

  • A key driver in selecting the appropriate spread is the nature of the asset pool backing the security because this will influence prepayment behavior.

  • Cash flow classes of the underlying loans:

  • 1. The underlying loans cannot be prepaid.

  • 2. The underlying loans can be prepaid, but refinancing is not a significant reason to prepay, so interest rate movements do not affect prepayment; this is most commonly the case with auto loan backed securities.

  • 3. The underlying loans can be prepaid and prepayment is largely driven by refinancing, so prepayment depends on the level of interest rate activity. This class is comprised of two sub-classes:

  • 3a) The current interest rate level determines prepayment; which would be the case with callable bonds.

  • 3b) Both the current interest rate level and the prior path of interest rate determine prepayment; which would be the case with mortgage backed securities and some other asset backed securities.

  • Securities backed by assets from cash flow classes 1 and 2 can be analyzed with the Z-spread.

  • The OAS can also be used for these securities because cash flows are not interest rate level dependent. In this instance, Z-spread = OAS.

  • Securities backed by assets from cash flow class 1 can be analyzed with the nominal spread; the Z-spread should be similar and is technically superior.

  • Cash Flow Class 3a: If a bond has an embedded option, the binomial interest rate tree model can be applied to generate an OAS; a callable corporate bond, for example.

  • Cash Flow Class 3b: If the security is backed by assets that are interest rate path dependent, such as a mortgage pass through security, a Monte Carlo based OAS should be applied.

  • OAS can be used for any debt security, but it is mandatory when borrower refinancing heavily influences future cash flows received by investors.

  • Analysts should not apply the nominal spread to evaluate bonds with embedded options as this spread will not account for the impact of the options on investor returns.

YIELD CURVE & RATE VOLATILITYAPPROPRIATE SPREAD
Flat & zero volatility.Analyst can use any spread as nominal = Z-spread = OAS.
Non flat & non-zero volatility.Conventional bonds without embedded options: can use either nominal or Z-spread, but Z is superior.
Non flat & non-zero volatility.Amortizing securities where interest rates do not influence prepayments: Z-spread.
Non flat & non-zero volatility.Securities whose prepayments are affected by current interest rates: OAS from binomial interest rate tree model.
Non flat & non-zero volatility.Securities whose prepayments are affected by interest rate levels and interest rate path: OAS from a Monte Carlo model.

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