Flight-to-quality or flight-to-liquidity?: evidence from the Euro-area bond market

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 nontrivial 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. (JEL G10, G12)