Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market
Cass Business School; Centre for Economic Policy Research (CEPR)
Michael W. Brandt
Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)
Kenneth A. Kavajecz
Syracuse University - Whitman School; University of Wisconsin, Madison - Department of Finance, Investment and Banking
NBER Working Paper No. w12376
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.
Number of Pages in PDF File: 38
Date posted: July 26, 2006
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