understanding Option adjusted spread in callable agency bonds.?

Question

How can two bonds with similar maturity but differenct coupons yield so much differently given similar oas. for example. FHLB 4.25 1/15/10 with a 12/06 call yields 5.04% with a 55 oas. Then compare FHLB 5.30 1/12/10 with a 1/07 call yields 5.49% with a 66 oas. That's about 45bps difference in yield. How do I understand this?

Answer 1

The first thing to understand is that no one has a clue what the yield of a mortgage backed security will actually be. The only thing they can say is "If prepayment is at this speed, then the yield is XXX." These yields are only the projected returns under one specific interest rate scenario. OAS looks at the average excess return over a large number of interest rate scenarios.

The 4.25 bond will not have as much option value as the 5.30 bond -- because one is closer to the money than the other. The difference in OAS tells you that ON AVERAGE, the second bond will outperform the first by 11 basis points. The Yields tell you that IN THIS SPECIFIC SCENARIO, it will outperform it by 45 basis points.