As various emerging and worsening global crises affect worldwide financial markets, you may have noticed that the result is almost always positive for U.S. Treasuries. You may wonder why this is so — shouldn't negative headlines from the geopolitical front also be harmful to Treasuries as well?
For stocks and higher-risk assets, it usually is. Both foreign and domestic stock markets usually exhibit weak price performance when the headlines are unfavorable. However, U.S. Treasuries — due to their status as one of the lowest-risk investments in the world — actually benefit when the investment backdrop becomes unstable. This phenomenon is known as the "flight to quality" or "flight to safety."
What Is the Flight to Quality, and How Can You Profit When It Takes Place?
The flight to quality is the dynamic that unfolds in the markets when investors are more concerned about protecting themselves from risk than they are with making money. During times of turbulence, market participants often will gravitate to investments where they are least likely to experience a loss of principal. These safe havens are typically the government bonds of the largest industrialized countries, particularly the United States.
At the simplest level, the flight to quality is an investor saying to him or herself, “Do I feel comfortable taking a risk, or am I better off keeping my money safe right now?” If enough people opt for the latter, the result is typically a rally in U.S. Treasuries.
The Flight to Quality at Work
Let’s look at an example. In mid-2011, the European debt crisis took center stage as the key driver of financial market performance. Investors became worried about a worst-case scenario for Europe — a potential default by Greece or one of the region’s other smaller countries, and/or the collapse of the euro as the region’s common currency. The result was a sell-off in stocks, commodities, and higher-risk areas of the bond market as investors moved cash out of assets likely to be hurt by negative headlines. At the same time, Treasury prices staged a mammoth rally and yields fell to record low levels. (Remember that for bonds, price and yield move in opposite directions.) For example, one-year U.S. Treasuries spent much of the year’s second-half trading with a yield below 0.20%, and, on a few occasions, the yield fell as low as 0.09%. As a result, Treasury prices soared.
This indicates that investors were willing to hold a one-year investment that paid virtually nothing — and was far below the rate of inflation — just for the privilege of keeping their money safe from the turmoil in the global economy. This is the flight to quality in action.
How Do Higher Risk Bonds Perform in the Flight to Quality?
For the bond market, this flight to quality trade has a flip side. Higher-risk segments of the market also tend to sell off when the news turns bad. High yield bonds, emerging market debt, and lower-rated bonds in the investment-grade corporate and municipal bond markets also tend to lose ground in accord with stocks.
The Flight From Quality
The flight to quality can also move in reverse. When positive news flow puts investors in a good frame of mind, the result is a typically stronger performance for the riskier segments of the markets and underperformance for U.S. Treasuries, meaning lower prices and higher yields.
What happened at the end of the U.S. financial crisis in the first quarter of 2009 is a good example of flight from quality in action. Believing that the era of bank failures and bailouts had passed, investors staged a massive move out of Treasuries and into stocks. As a result, the yield on the 10-year Treasury rocketed from about to 2.5% to 4.0% in just three months as its price plunged – a classic flight from quality. (Keep in mind, prices and yields move in opposite directions.)
For individual investors, the most important takeaway from this discussion is that it isn’t accurate to view “the bond market” as a hiding place in times of trouble. In fact, it is usually only the highest-rated securities (such as Treasuries) that are seen as being least likely to default that perform well when risk appetites evaporate. As a result, be sure you understand what type of bond or bond fund you own before you assume you’re safe from negative headlines.