Z-spread
Capital MarketsThe constant spread added to every point on the zero coupon curve that makes a bond's discounted cash flows equal its market price.
Also written: zero volatility spread
The Z-spread discounts each of the bond's cash flows at the zero coupon rate appropriate to its own date, plus one constant spread applied throughout, and solves for the constant that reproduces the traded price.
That fixes the weakness in a nominal spread. The whole shape of the curve is used rather than a single maturity point, so the measure does not depend on which benchmark bond somebody happened to select, and it stays reliable when the curve is steep or the bond's cash flow profile is unusual.
For a bond with no embedded options the Z-spread is the right measure and is exactly equal to the option adjusted spread, because there is no option value to strip out. It also adds no model risk, which is a real advantage over an option adjusted spread.
Where it breaks down is optionality. On a callable bond, part of the Z-spread is compensation for the call the investor has effectively sold to the issuer rather than for credit risk, so comparing the Z-spread on a callable bond with the Z-spread on a bullet will make the callable look cheap when it may not be.
Worked example
Two bonds from the same issuer, same maturity, both show a Z-spread of 250 basis points. One is a bullet and one is callable in two years.
They are not equally attractive. On the bullet the whole 250 is credit and liquidity. On the callable a chunk of it is the price of the option, so the credit compensation is less than it looks.