Flight to quality among investors happens when investors make decisions to sell what they perceive to be high risky investments and purchase the safest possible investments. Safer investments will be in the form of government backed Treasury bills which are usually considered risk free. It can also be in the form of precious metals like gold. Stocks, money market, corporate bonds and other investments that are not government backed are usually classified as high risk by investors.
Financial crisis, slow economic growth, corporate scandals, high oil prices, political unrest and other factors can cause uncertainty in the financial markets. Flight to quality normally follow, or is concurrent with this uncertainty. When the market is uncertain about the future, capital will flow to more liquid or low risk assets. Investors will opt for low risk assets with lower profits to reduce their risk exposure.
Flight to quality can affect the whole financial market or part of it. It can affect one portion of the stock market, for example, investors can sell stocks in high-risk companies and invest in low-risk companies in the same stock market. They can also sell junk bonds and purchase high grade bonds in the same bond market. Flight to quality can also happen between countries or regions.The Eurozone financial crisis caused some investors in Italy to move their money to Switzerland, according to Christian De Prati, former CEO of Merrill Switzerland. Gold Retailer Pro Aurum reported in a surge in gold bar sales during the crisis.
Flight to quality is not a problem when it’s done by few investors. When an underlying problem comes to light however, it will cause panic among investors and there will be flight to quality. When that happens, asset prices will fall as market participants reassess and re-price the risk. Liquid investors will start engaging in speculative behavior for their own benefit. Capital will move towards Treasury bills, increasing demand and causing yields to fall.
During the credit crisis of 2008, there was severe flight to quality towards Treasury bills. Many investors had suffered losses in nearly every market and wanted some guarantee that they were not going to make further losses. Demand for Treasury bills increased, despite the near zero return, to the extent that they traded at -0.01% on December 9, 2008. Investors were willing to suffer a small guaranteed loss rather than invest in uncertain assets.
There is usually a negative correlation between stocks and bonds during a financial crisis. Stocks are regarded as high-risk investments by many investors. This is because in a financial crisis stocks are usually the first to go down. Losses from the stock market can be very high.
The problem with flight to quality is that it worsens a bad situation, hence the many ‘schools of thought’ about government intervention in the financial market.