Interest rate differentials (the spread) between the highest and lowest quality fixed income investments are the talk of Wall Street. Recent events in the subprime and collateral lending markets have seemingly provided the impetus for spreads to widen to levels some analysts argue are more representative of the inherent investment risk, after spending the better part of the last five years well below the levels prevailing at the turn of the century. Generally speaking, a wider credit spread means that lower quality bonds are carrying higher credit risk relative to high quality bonds.
While many in the media and on Wall Street proclaim a return to normalcy in the credit markets, I offer up the other side of the argument. Normalcy is a subjective concept, especially when the rules dictating normalcy change. In my view, the Sarbanes-Oxley Act of 2002 (SOA), which may be the most important piece of legislation affecting corporate America’s financial reporting practices since the Securities Acts of 1933 and 1934, has changed the way investors should think about credit spreads. SOA effectively improved the availability of information flow to investors, which has had demonstrable implications not only for perceived risk levels in the equity market (a subject covered occasionally in Insight Line and widely throughout academia), but also for those of the fixed income market.
In fact, the outcome was all but foretold by former Federal Reserve Board Chairman Alan Greenspan two years prior to the enactment of SOA. In a 2000 speech on the topic of technology and information management systems, Dr. Greenspan suggested, “Because the future is never entirely predictable, risk in any business action committed to the future—that is, virtually all business actions—can be reduced but never eliminated. Information technologies, by improving our real-time understanding of production processes and the vagaries of consumer demand, are reducing the degree of uncertainty and, hence risk.”1
This led me to ask, if information technology reduces risk for a company’s management—the risk of conducting business—could it also reduce risk for a company’s investors? After all, the more information investors receive, the better their ability to make an informed investment decision.
While the application of better information flow to the stock market was obvious early on in SOA’s implementation, it is only with the benefit of hindsight that we can see its effects on the fixed income markets. As the chart below from Ned Davis Research2 seemingly attests, the inception of the SOA in July of 2002 (with full implementation by the end of 2004) appears to have redefined—at least when viewed in the context of the last 10 years—normalcy in credit spreads.
If I’m correct that SOA provides investors with a new level of clarity and insight into the financial working of any corporation, I believe it reasonable to conclude the investment landscape for fixed income investors will never be the same. Moreover, if normalcy indeed has been redefined, then Wall Street has likely misinterpreted the recent credit spread widening. At a time when many strategists suggest that the current credit spreads foretell further downward price correction for lower-grade fixed income investments, I offer an alternative view: might this be a buying opportunity?
1 Greenspan, Alan, “Technology and the Economy,” remarks before the Economic Club of New York, New York, New York, January 13, 2000
2 Agencies, Mortgages and Corporate Yield Spreads, chart B0384, ©2007 Ned Davis Research, Inc. (data shown as of 08/06/07)
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