Do bond investors demand credit quality or liquidity? The answer is both, but at different<br/>times and for different reasons. Using data on the Euro-area government bond market,<br/>which features a unique negative correlation between credit quality and liquidity across<br/>countries, we show that the bulk of sovereign yield spreads is explained by differences<br/>in credit quality, though liquidity plays a nontrivial role, especially for low credit risk<br/>countries and during times of heightened market uncertainty. In contrast, the destination of<br/>large flows into the bond market is determined almost exclusively by liquidity.We conclude<br/>that credit quality matters for bond valuation but that, in times of market stress, investors<br/>chase liquidity, not credit quality. (JEL G10, G12)

Abstract We develop an asset pricing model with stochastic transaction costs and investors with heterogeneous horizons. Depending on their horizon, investors hold different sets of assets in equilibrium. This generates segmentation and spillover effects for expected returns, where the liquidity (risk) premium of illiquid assets is determined by investor horizons and the correlation between liquid and illiquid asset returns. We estimate our model for the cross-section of U.S. stock returns and find that it generates a good fit, mainly due to a combination of a substantial expected liquidity premium and segmentation effects, while the liquidity risk premium is small.