Lorenzo Naranjo and Carmen Stefanescu argue that European sovereign spreads are all about the flight to liquidity, not the flight to quality

The European sovereign debt crisis has put enormous strain on the cost of borrowing for some European countries, such as Italy or Spain. Even though this situation has reversed during the first half of 2013 to more sustainable levels, markets are still cautious of buying the debt of these countries. At the same time, countries such as France and Germany have been able to keep borrowing rates at low levels.

Perhaps the most extreme example of this contradictory behaviour occurred during July and August 2012, when there were alarming rumours that Spain was having increasing economic difficulties and might need a sovereign bailout. The effect on markets was clear.
The average yield of two-year Spanish sovereign bonds was 498 basis points in July and 383 basis points in August. On the contrary, the average yield of two-year German sovereign bonds during the same period was -2.95 basis points in July and -3.57 basis points in August. In other words, at the same time as Spain was seeing the cost of rolling over its debt increasing beyond sustainability, Germany was borrowing at negative, nominal yields.

These numbers suggest that, in times of economic distress investors rebalance their portfolios towards less risky and more liquid securities. This phenomenon is commonly referred to as a flight to quality and a flight to liquidity.

There is agreement in the finance literature that the best way to gauge credit risk is by looking at credit-default swap (CDS) spreads. The CDS is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the ‘spread’) to the seller and, in exchange, receives a pay-off if the loan defaults. In the case of government debt, investors use default swaps to express their views about the creditworthiness of a government, and to protect themselves in the event of a default, debt restructuring or credit rating cut.

CDS spreads are a good way to assess risk as it has been shown to be insensitive to liquidity premia and risk of the underlying debt instrument. Therefore, if flight to quality is the reason pushing German yields down while at the same time pushing Spanish yields up, we should be able to see this in the data.

We have collected daily five-year CDS spreads for France, Germany, Italy and Spain from the beginning of January 2011 to the end of March 2013. We chose to start in 2011 since this period highlights the worst of the crisis. We then computed pairwise correlations of daily changes in CDS spreads for all these countries.

Surprisingly, we found all correlations to be positive and significant, suggesting that on average, credit risk co-moves during the sovereign crisis, even for countries like Germany.
Of course, the correlation of CDS changes between Germany and Spain (0.63) is not as high as between Germany and France (0.82), but it is still significant from an economic and a statistical point of view.

These correlations contrast with the ones that we obtain for sovereign bond yields. If we repeat the same exercise with daily five-year sovereign bond yields, we find that even though the correlation between Germany and France is still positive (0.51), it is negative for Germany and Italy (-0.30) and Germany and Spain (-0.25). We obtain similar results if we use two-year or 10-year bond yields, or if we analyse sub-periods of the data.

These results suggest that flight to quality may not be the reason behind the negative correlation observed in the cost of borrowing of Germany and countries such as Italy or Spain. Changes in credit quality are a long-term concern related to changes in fiscal discipline, which is associated in turn with changes in the political landscape. Therefore, credit quality may become a dominant part of the yield at longer horizons. At a short to medium horizon, the flight to liquidity may be the driving factor for the results. Indeed, the correlation of daily changes in CDS spreads and bond yields is negative for Germany
(-0.42) but positive for all other three countries (0.14 for France, 0.69 for Italy, and 0.71 for Spain).

Episodes of financial turmoil are characterised by investors’ fear that they will be caught with illiquid securities in their portfolios, a dread that is more relevant for institutional investors. This concern is to be determined by the institutional features of the European bond market, where sovereigns polarise new issues of government bonds around the five and 10-year horizon. Therefore, the impact of liquidity on sovereign yields is substantially increased especially for the medium maturity bonds. When investors rebalance their portfolio towards less risky assets, in response to a perceived temporary increase in uncertainty, short-term liquidity and transaction-cost concerns become relatively more important, pushing yields up.

Recent research confirms this hypothesis. Indeed, a worsening in credit risk could cause a flight to liquidity by reducing the ability of sovereign countries to roll over their existing debt. Also, empirical studies suggest that the destination of large flows into the bond markets is determined almost exclusively by liquidity. Hence, the negative correlation between changes in yields of German and Spanish sovereign bonds could be due to portfolio rebalancing of large institutional investors. During periods of large flows into – or out of – the bond market, liquidity explains a substantial proportion of sovereign yields, consistent with a heightened impact of trading costs on bond prices. This evidence suggests that, while credit quality matters for bond valuation in the long run, in times of market stress, investors chase liquidity, not credit quality.

Whatever it takes
On July 26th 2012, Mario Draghi, president of the European Central Bank (ECB), said: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” These words eventually calmed markets down. Of course, with these words, the ECB explicitly guaranteed that European governments will receive the funds needed to roll-over any debt commitments. Implicitly, the ECB was also guaranteeing to provide the necessary liquidity for the markets to function.

Within this framework, it becomes interesting to analyse the case of France. We have seen that credit risk for France fluctuates positively with the rest of the euro-zone.
Nevertheless, France has benefited from the depth and liquidity that its debt market offers to investors. Even though the correlation of changes in French bond yields has not been negative with Italy or Spain, this correlation has not been negative either with German bond yields. As a result, the spread of French sovereign bonds is significantly lower than other European states.

Lorenzo Naranjo and Carmen Stefanescu are both assistant professors of finance at ESSEC Business School