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 differenttimes and for different reasons. Using data on the Euro-area government bond market,which features a unique negative correlation between credit quality and liquidity acrosscountries, we show that the bulk of sovereign yield spreads is explained by differencesin credit quality, though liquidity plays a nontrivial role, especially for low credit riskcountries and during times of heightened market uncertainty. In contrast, the destination oflarge flows into the bond market is determined almost exclusively by liquidity.We concludethat credit quality matters for bond valuation but that, in times of market stress,…