RFS Advance Access originally published online on February 9, 2008
Review of Financial Studies 2009 22(3):925-957; doi:10.1093/rfs/hhm088
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Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market
HEC, University of Lausanne and Swiss Finance Institute
Fuqua School of Business, Duke University and NBER
School of Business, University of Wisconsin
Address correspondence to Kenneth Kavajecz, School of Business, University of Wisconsin—Madison, 975 University Avenue, Madison, Wisconsin 53706; telephone: (608) 265-3494; e-mail: kkavajecz{at}bus.wisc.edu.
JEL: G10, G12
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Abstract |
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Do bond investors demand credit quality or liquidity? The answer is both, but at different times and for different reasons. Using data on the Euro-area government bond market, which features a unique negative correlation between credit quality and liquidity across countries, we show that the bulk of sovereign yield spreads is explained by differences in credit quality, though liquidity plays a nontrivial role, especially for low credit risk countries and during times of heightened market uncertainty. In contrast, the destination of large flows into the bond market is determined almost exclusively by liquidity. We conclude that credit quality matters for bond valuation but that, in times of market stress, investors chase liquidity, not credit quality.
We gratefully acknowledge the helpful comments from seminar participants at Notre Dame University, University of North Carolina, University of Wisconsin, the Winter Research Conference at the Indian School of Business, and the 2006 MTS conference on financial markets. We have also benefited greatly from the comments of Shane Corwin, Alfonso Dufour, Joel Hasbrouck, Paul Schultz, Richard Sheehan, Matt Spiegel, and two anonymous referees. All remaining errors are our own. Financial support from the Swiss National Centre of Competence in Research and from the Global Capital Markets Center at Duke University is gratefully acknowledged.