What OAS Analytics Often Miss
Puts and calls are not the only fixed coupon bond options
by Andy Kalotay
The theme of this second post in our series on option-adjusted-spread technology is completeness of coverage. If you recall my first blog, OAS is a way to more precisely compare prices of similar securities, by adjusting for optionality. The terminology gives some the mistaken impression that OAS is appropriate only to bonds with options. In fact, it is universally applicable, including to optionless bonds. Below we focus on fixed coupon bond options.
Unlike stock options, which trade separately from the underlying stock, bond options are ‘embedded’ – they are an integral part of the bond. The most common options in fixed coupon bonds are calls and puts. However, you should be aware of less familiar ones, such as extension, pay-in-kind, and sinking fund options. Adding to the complexity, there are bonds with investor call options, which can be used to purchase additional bonds from the issuer at a fixed price. To avoid unpleasant surprises, investors should be aware of how ‘issuer’ options can go against them, and vice versa. Index providers and pricing services should be versed in all embedded options.
Before you put your money on the line, make sure that your system can handle the full valuation task. Professional-quality OAS analytics should be comprehensive. When it comes to complex options, every one of them should be accounted for. Omission, due to ignorance or lack of technical know-how, can produce disastrous results.
Standard OAS analytics can handle American-type calls and European-type puts, but what about less familiar options? Consider, for example, the pay-in-kind feature: the issuer can make coupon payments with cash, or issue additional bonds in some specified amount. The choice will depend on the bond’s price; if it is sufficiently low, paying in kind is preferable. Can your analytics cope with PIKs?
Sinking fund bonds are particularly challenging. They were introduced in Britain, in a somewhat different form, in the 18th century. Some even say that they contributed to Britain’s victory over Napoleon. In a modern-day sinker, the principal must be retired gradually prior to maturity; however, it is far more complex than an amortizing bond. An investor in the latter is guaranteed pro rata principal payments. In contrast, for a sinker the only guarantee is that the principal will be returned; the timing is uncertain. The basic reason is that the issuer can satisfy the sinking fund not only by paying cash, but also by delivering actual securities purchased in the market. If the price is below par, delivery is the cheaper alternative. Investors refusing to sell may end up holding low coupon bonds until maturity. Clearly this delivery option is of significant value to the issuer, and of commensurate detriment to investors.
There is more to the delivery option: its value depends on liquidity. If the bonds are illiquid (perhaps because they have been cornered by a major investor, or because investors are loss-constrained), the issuer may not be able to buy bonds at a discount, no matter how high rates are, and will have to pay par. In this case illiquidity actually helps buy-and-hold investors.
What if rates decline? Sinking fund bonds may be callable at a premium over par, in the customary manner. However, the issuer has the option of calling only part of the issue at a premium, and retiring the rest at par via the sinking fund. In addition, there may be a so-called double-up option, which allows the issuer to retire bonds in excess of the specified amount at par. Can you think of a reason why the issuer should not double up when the market price is above par? See how we advised the World Bank on how to approach this problem.
These issuer-options (delivery, call, and double-up) may make you wonder if you should ever come close to a sinker without the proper analytics. And there is one more option to consider: designation. The issuer may be holding in treasury a block of bonds purchased previously. These can be used to satisfy the sinking fund if the price is low, or continue to be held if the price is above par. For a detailed discussion of sinking fund options, see “The Valuation and Management of Bonds with Sinking Fund Provisions.”
The table below displays the values of selected options of a new 30-year sinker. If the issue is liquid, the option is worth 5.7% of par to the issuer, to the disadvantage of the investor. However, if say 40% of the bonds are accumulated, the value of the option would decline to about 3.6 points.
As we see, a sinker can have several interrelated ‘issuer’ options: call, acceleration, delivery, and designation, with liquidity being an additional factor. If you overlook any of these, you may mistakenly think that the bonds are cheap. Valuing such path-dependent options is challenging; the good news is that it can be done accurately and fast.
Bottom line: Your OAS analytics should cover not only calls and puts, but all options. Ignore them at your peril!
Stay tuned for: Trust But Verify — How to test your OAS analytics for accuracy.
About Kalotay Analytics
For more than twenty-five years, Kalotay Analytics’ flagship BondOAS™ has been at the core of the world’s most sophisticated fixed income valuation systems. From real-time pricing of bond ETF’s to instantaneous risk analysis, BondOAS performs computationally intensive calculations with the precision and speed required by today’s highly demanding market participants.