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

Alessandro Beber1,2; Michael W. Brandt3; Kenneth A. Kavajecz4

1 Swiss Finance Institute · 2 University of Lausanne · 3 Duke University · 4 University of Wisconsin–Madison

Review of Financial Studies 2009 open access

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)

DOI
10.1093/rfs/hhm088
Volume
22 (3)
Pages
925-957
Language
en
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