Following the dramatic spread-widening and subsequent sharp reversal during the first quarter, the Barclays Corporate Index option-adjusted spread (OAS)1 rallied back to roughly unchanged for the year by the beginning of the second quarter. The spread rally continued into the second quarter, as fears about growth in China subsided and sentiment in the oil and basic materials markets steadily improved. However, as the May new issue calendar reached the highest monthly level on record, and as the Federal Reserve (Fed) stepped up its hawkish rhetoric, the rally stalled and spreads widened modestly into June. And then things got interesting.
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1Option-adjusted spread is the spread relative to a risk-free interest rate, usually measured in basis points (bp), that equates the theoretical present value of a series of uncertain cash flows of an instrument to its current market price. OAS can be viewed as the compensation an investor receives for assuming a variety of risks (e.g. liquidity premium, default risk, model risk), net of the cost of any embedded options. A larger OAS implies a greater return for greater risks.