The flight to quality

The flight to quality is a market dynamic that unfolds when investors take measures to protect themselves from risk. Flight to quality is common during times of turbulence when market participants often will tend to investments where they are least likely to meet a loss of principal. The safe havens are often in the form of government bonds of the largest industrialized countries. One example of flight to quality is the mid-2011, the European debt crisis. The crisis took center stage as a key driver of financial market performance. During this time, investors were worried about a worst-case scenario for Europe in the case of a potential default by Greece or the collapse of the euro as the region’s common currency. The investors resulted in a sell-off in stocks and higher-risk areas of the bond market in an effort to move cash out of assets that were likely to be hurt by negative headlines. During the same time, Treasury prices were also affected as yields fell to record low levels. For example, one-year U.S. Treasuries spent traded with a yield below 0.20% for the second half the year. On a few on a few occasions, the yield recorded a low of 0.09%. This indicated that investors were more willing to hold a one-year investment that did not give returns in order to keep their money safe from the problems associated with the global economy. (Fuerbringer, 2005)

A flight to quality can be experienced during any period of market uncertainty. For example, U.S Treasury bond yields fell to new lows in August 2014 due to geopolitical worries. The Geopolitical risks in Iraq, Ukraine, and Gaza, caused a panic in the financial markets resulting to a flight to quality. Investors are quick to analyze a company’s fundamentals such as earnings stability, profitability track record and balance sheet strength in determining their investment’s "margin of safety." The analysis ensures that they purchase stocks that at an adequate discount to their intrinsic value. The investors evaluate the quality of a firm in various dimensions including Financial Leverage, Profitability, Asset Growth, Earnings Quality and Corporate Governance. The dimensions provide insights into a firm’s quality characteristics from different angles. Earnings Quality and Profitability are income statement related measures of quality while Asset Growth and Financial Leverage are linked to the balance sheet of the firm. Different descriptors are often used to define each of the dimensions. Institutional investors often replicate a range of quality indexes with the descriptors, depending on their capacity requirements and objectives. The prospects of the dimensions influence investors in their decisions regarding the flight to quality.

In the event of market uncertainty, investors prefer Treasury securities as they are characterized by low risk. The United States typically issues Government debt in the form of U.S. Treasury securities. Treasuries are widely regarded to be the safest securities investments since they lack significant default risk. It is, therefore, no surprise as investors turn to Treasuries in periods of increased uncertainty. In the recent financial crisis, the demand for Treasuries was sufficiently large resulting to a significant increase in prices of government securities. On the other hand, corporate bonds have a higher risk of default. Investors are rewarded with a higher yield for taking this relatively higher risk. (Austin, 2009)

In August 2007, when the mortgage market began to slide, the yields on short-term Treasuries fell sharply. While the supply of Treasuries was relatively constant during this period, yields on both long-term and short-term government securities continuously fell. The decline in the short-term Treasuries reflected the greater demand for liquidity during the period as investors were increasingly unwilling to purchase longer-term assets. The uncertainty in the mortgage market was also a factor that influenced investors to flight to quality. Investors switched from other debt instruments into government securities as they believed that risk was primarily concentrated in the mortgage market. (Bill, 2007)

On September 2008, the collapse of Lehman Brothers signaled the beginning of a financial panic among investors. The period experienced increased selling pressure by panic-stricken investors. The demand for U.S. Treasuries increased as corporate bonds experienced lowered prices and increased yields. The massive flight to quality was experienced despite U.S. securities having Yields to near zero in November. This anomalous behavior in the market explained by a significant increase in the demand for U.S Treasuries can be termed as "the flight to quality" in the period of financial crisis. (Zeng, 2014)

The flight to quality trade has a different side in the bond market. Higher-risk segments of the market also tend to sell off when prospects are not positive. Emerging market debt, High yield bonds and lower-rated bonds in the municipal bond markets and investment-grade corporate also tend to lose ground to stocks. The flight to quality may also move in reverse. When there are positive prospects for investors, the result is often underperformance for U.S. Treasuries and stronger performance for the riskier segments of the markets. An example of this scenario is the end of the U.S. financial crisis in 2009. Investors massively moved out of Treasuries into stocks believing that the era of bank bailouts and failures had passed. As a result, the 10-year Treasury yield recorded an increase from about to 2.5% to 4.0% in just three months. (Austin, 2009)

References

Bill Barnhart (2007) Market report. Most investors are banking on a flight to quality. Chicago Tribune.

Fuerbringer Jonathan (2005, MAY 22, 2005) MARKET WEEK: Flight to Quality Cuts Yields Newyork times.

Zeng Min (2014, August 9) Credit markets: U.S. Treasury Bond Yield Hits Lowest. The Wall Street Journal. P.1

(2007, May 9). Wall Street Closes Flat After Early Losses. New York Times. p. C10.

Austin S. (2009, November 3) The Daily Start-Up: Hopping On The Flight To Quality. Wall Street Journal

Sherry Roberts is the author of this paper. A senior editor at Melda Research in Buy Term Papers Online if you need a similar paper you can place your order for a custom research paper from Custom Research Paper Writing.

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