Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market

Abstract

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 non-trivial 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.

Permanent trading impacts and bond yields

“…During periods of higher uncertainty, bonds with higher bid-ask spread or lower market depth require significantly higher yields. Consistent with Beber, Brandt and Kavajecz (2009), our results indicate that liquidity is more important than credit quality in explaining the behaviour of asset prices during 'flight-to-quality' and 'flight-to-liquidity' events.…”

“…Instead, we consider the swap curve as the reference curve, a procedure which has become increasingly common in the recent literature (e.g. Blanco, Brennan and Marsh 2005;Houweling, Mentink and Vorst 2005;Beber, Brandt and Kavajecz 2009). It is argued that although swap rates inherently embed counterparty default risk, the swap curve has several advantages over the government bond yield curve, including the existence of a single swap curve in the euro area and the fact that swap rates are not subject to different tax treatments and repo specialness.…”

“…For the definition of high bond market volatility periods, we follow Beber, Brandt and Kavajecz (2009) and consider the implied volatility obtained from the prices of swaptions, the one-month option contract on the one-year euro swap rate. From a theoretical viewpoint, volatility is positively related to the price of liquidity.…”

Estimation of the Term Structure of CDS-AdjustedRisk-Free Interest Rates

“…In particular, government bonds issued by the United States and Germany have been presumed to be risk free. Even after the global financial crisis of 2007-2008, German government bonds are regarded as risk-free assets, and for other euro-area countries, the yield spreads over the German benchmark yield are regarded as risk premiums (Remolona et al [2008]; Beber et al [2009]; Favero et al [2010]; Oliveira et al [2012]; Calice et al [2013]). Thus, the euro-area government bonds issued by countries except Germany are not regarded as risk free.…”

Crisis-Robust Bond Portfolios

“…However, the FTQ effect undermines this argument. The fact that investors shift from risky to safe securities during crises (Beber, Brandt, and Kavajecz [2006]) causes a decline in the correlations between risky and safe assets during such periods (Stivers and Sun [2002], Baur and Lucey [2006]). This is good news for diversification benefits.…”