hard · Asset-Backed Securities
A 3-year amortizing ABS bond is priced at par with a 6.5% coupon. The Treasury curve is upward sloping: 1-year at 4.0%, 2-year at 4.5%, and 3-year at 5.0%.
If the nominal spread is calculated at 150 basis points over the 3-year Treasury, how would the Zero-Volatility Spread (Z-spread) typically compare, and why?
- The Z-spread would be higher than 150 bp because it accounts for the 'convexity cost' of the amortizing principal which is ignored by the nominal spread.
- The Z-spread would be lower than 150 bp because the bond's early cash flows are discounted at 1 and 2-year spot rates that are lower than the 3-year benchmark used for nominal spread.
- The Z-spread would be irrelevant because for an amortizing bond, only the Option-Adjusted Spread (OAS) correctly captures the timing of cash flows.
- The Z-spread would be exactly 150 bp because both measures assume a single weighted-average life for discounting all principal and interest payments.
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