What's the difference between OAS, Z-spread, and nominal spread, and when should I use each?

This is one of the most tested concepts in CFA Level II Fixed Income. Each spread measure has a specific use case, and confusing them is a common exam trap.

Three Spread Measures

The Relationship:

For an option-free bond: OAS = Z-spread (no option to adjust for)

For a callable bond: Z-spread = OAS + Option cost (in spread terms)

For a putable bond: Z-spread = OAS - Option cost

Why the Nominal Spread Falls Short

The nominal spread simply compares two YTMs. The problem: it ignores the shape of the yield curve. Two bonds with the same YTM spread can have very different risk profiles if their cash flows hit different parts of the curve.

Example — Hartwell Financial 6% 10-year Callable Bond

Consider Hartwell's callable bond trading at $98.50:

• Benchmark 10-year Treasury yield: 4.00%
• Bond YTM: 6.35%
• Nominal spread: 6.35% - 4.00% = 235 bps

Now compute the Z-spread by adding a constant spread to each Treasury spot rate:

• Z-spread: 220 bps (lower than nominal because the upward-sloping spot curve already accounts for some of the yield difference)

Finally, use a binomial tree with interest rate volatility to compute OAS:

• Option cost: 45 bps (the value the call option takes from bondholders)
• OAS: 220 - 45 = 175 bps

Why OAS Is 'The Real Spread':

The OAS strips out the option effect, leaving only compensation for credit risk and liquidity. This lets you compare:

• Hartwell callable (OAS = 175 bps) vs a similar option-free bond (Z-spread = 180 bps)

Now you can see the callable bond actually offers 5 bps less compensation for credit/liquidity risk. The nominal spread of 235 bps was misleading — it included 45 bps of option cost that benefits the issuer, not you.

Decision Framework:

1. Comparing option-free bonds: Z-spread is appropriate
2. Comparing bonds with different embedded options: OAS is the only fair comparison
3. Quick screening: Nominal spread is fine for rough filtering

Exam Tip: If a CFA Level II question asks 'which bond offers better value' between a callable and a non-callable, you MUST use OAS for the callable. Using Z-spread would overstate the callable bond's attractiveness.

Deepen your spread analysis skills in our CFA Level II course.