Option-Adjusted Spreads and Default Probabilities for Corporate Bonds:
Observations on the Investment Grade and High Yield Markets

Teri Geske

It is well known that corporate bonds offer investors a positive option-adjusted spread (OAS) to Treasuries. Indeed, if a bond valuation model produces an OAS that is negative we must either conclude that the inputs are bad (the price is too high), or that there is something wrong with the model. Investors must be offered an incentive to hold corporate bonds versus comparable maturity, default risk-free securities (e.g., U.S. Treasuries); otherwise, investors would sell the corporates in favor of the default risk-free, and more liquid, Treasuries and the supply/demand imbalance would push the prices of the corporate bonds lower, thus increasing their OAS.