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 VOLATILITY	APPROPRIATE 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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