As more hospital bonds are being sold with non-traditional call provisions, comparing pricing between issues has become more challenging. We recently took the bull by the horns and added option-adjusted spread (OAS) methodology to our independent bond pricing advisory and underwriter evaluation platform.
In recent months, determining how municipal bonds price relative to market spreads has become more challenging for hospitals and other healthcare issuers, for several reasons.
First, since tax reform, municipal bond issuance in general and in healthcare in particular has been limited. Second, municipal bonds continue to be illiquid, with only 1% of all municipal bonds traded daily. With fewer new issues coming to the primary market and infrequent trading in the secondary market, it’s less likely that hospitals –along with their underwriters and their independent advisors– will find enough data to support a valid comparison of how their bonds sold in the public markets relative to other comparable issues.
The third reason is that more bonds are being sold with non-traditional call features. Bond pricing embeds the value of optional redemption provisions, so prices for bonds with different call features cannot be directly compared. By adjusting for the call option, the option-adjusted spread or “OAS” calculation permits a direct comparison where one was previously not valid.
OAS is not new, it was invented about 30 years ago by the mortgage research group at Salomon Brothers. While it has become the standard for taxable bonds, OAS has been slow to catch in the tax-exempt world.
Unlike traditional measures of credit spread such as yield to call or yield to maturity, OAS is calculated as the spread relative to a risk-free, optionless benchmark yield curve. This optionless curve is derived by stripping the optionality from a standard callable yield curve (in the muni world, one of the AAA GO curves, such as MMD or BVAL). The adjustment is necessary because the muni benchmark curves report yield to worse based on a 5% coupon and a 10-year par call. For “quants”, building an optionless curve is relatively straight forward, but for the layperson without access to a Bloomberg terminal, it can be dauting, with esoteric concepts like multinomial, multifactor rate trees.
Key to the optionless curve is an assumption about future interest rate volatility, which has ranged from approximately 10% to 15% over the last 10 years.
Once the optionless curve is ready, any given bond maturity can be run through the model along with its call provisions, to calculate OAS. The resulting OAS will be different from the traditional spread and for purposes of analyzing pricing, it should only be compared to the OAS for other bond issues.
By allowing a direct comparison of issues with different call options, OAS helps increase pricing transparency in the muni bond markets.
For a general discussion of bond pricing, see http://www.hfapartners.com/244-were-your-bonds-priced-below-market.