Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market Alessandro Beber, Michael W. Brandt and Kenneth A. Kavajecz∗This version: June 2006 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. ∗Beber is at HEC, University of Lausanne, Brandt is at the Fuqua School of Business, Duke University and is also affiliated with the NBER, and Kavajecz is at the School of Business, University of Wisconsin - Madison. We gratefully acknowledge the helpful comments from seminar participants at Notre Dame University, University of North Carolina, and the University of Wisconsin. We have also benefited greatly from the comments of Shane Corwin, Joel Hasbrouck, Paul Schultz and Richard Sheehan. All remaining errors are our own. Address correspondence to Kenneth Kavajecz, School of Business, University of Wisconsin – Madison, 975 University Avenue, Madison, Wisconsin 53706. Phone: (608) 265-3494 or [email protected]
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