Final answer:
When interest rate volatility declines, the OAS for putable bonds is likely to increase.
Step-by-step explanation:
When interest rate volatility declines, the Option-Adjusted Spread (OAS) for putable bonds is likely to increase. The OAS represents the compensation investors receive for taking on the risk associated with the put option embedded in the bond. As interest rate volatility decreases, the value of the put option also decreases, causing the OAS to increase.
For example, let's say a putable bond has a yield of 5% and an OAS of 100 basis points when interest rate volatility is high. As interest rate volatility declines, the value of the put option decreases and the OAS could increase to 150 basis points. This higher OAS reflects the increased compensation investors require for holding the bond.
In summary, as interest rate volatility declines, the OAS for putable bonds is expected to increase, since the reduced volatility reduces the value of the put option, leading to higher compensation for investors.