Wednesday, September 3, 2008

Bonds Sure Look Cheap...

The option adjusted spread to Treasuries of the Lehman Aggregate Index is currently at a historic level. Is this a buying opportunity, a view of things to come, or just mispriced options?


  1. How does the spread look if you change the option pricing, say by assuming that prepayment rates will decline 50% from historic rates?

  2. That's the million dollar question, right? Well the Lehman Agg is composed of ~40% mortgages, which currently have an OAS of roughly 150 bps (duration estimated at ~5 years). The spread between 5 and 7 year Treasuries is ~40 bps. ~40 bps * ~40% = 16 bps (ignoring optionality of corporate bonds). So lets say 16 bps from the optionality of mortgages. In other words, in my opinion... not much.