In the world of investing there are many expressions and phrases that are commonly used among professionals, but that can sometimes seem quite confusing to the general public. While not as bewildering as the actual financial market terminology and technical jargon, many popular investing catch-phrases serve a useful and effective purpose in communicating overall market conditions, performance of individual asset classes, and investor sentiment in a succinct and incisive manner. The “flight to quality” is one such expression that carries a lot of meaning in a simple phrase.
The easiest way to understand “flight to quality” is as a market condition when investors transfer capital from relatively riskier asset classes to relatively safer asset classes. This has the potential to take many different forms, although the most common flight to quality trade is from growth stocks to U.S. Treasuries. Typically the flight to quality is either caused by or coincident with some sort of negative news event or economic data that unsettles the financial markets.
There are a variety of different combinations of financial market metrics that can be useful in determining if the market is experiencing a flight to quality trend. Overall, a flight to quality occurs when investors prefer to take their money out of more volatile asset classes like corporate equities and put it into less risky assets like sovereign debt instruments. In the United States, the most fundamental and often used market benchmarks investors watch to evaluate the appetite for risk is the relation of U.S. Treasury securities to the Standard and Poor’s 500 Index.
When the market is experiencing a flight to quality this pairing is inversely price correlated, meaning the two markets would move in opposite directions; with Treasury securities increasing in price and the S&P 500 Index decreasing in value. Described differently, in this flight to quality scenario, investors would pull their capital out of stocks in the S&P 500 Index and pile into U.S.Treasury securities, which would drive prices up and interest yields down. The interest rate yield to maturity on U.S. Treasury securities is known as the risk-free rate, as these debt instruments are acknowledged by investors as the safest possible investment available that offers a coupon, or rate of return.
Under different iterations of the flight to quality, other market indicators may unveil investors’ desire to revalue risk. For instance, given some negative reports in Asia prior to the stock market’s opening bell that could potentially effect the semi-conductor industry, there are trading sessions on the major stock exchanges where a relatively riskier index like the NASDAQ 500 declines in value, while the Dow Jones Industrial Average of thirty of the largest U.S. companies actually goes up. Likewise, a scandal regarding technology companies could result in capital being reallocated from those stocks and being parked into blue-chip consumer staples type of stocks that are viewed by investors as safer and less volatile.
A last example of the flight to quality has to do with the way capital moves internationally in the global financial markets. This can take place in stock markets when fears arise about the economy of an emerging nation investors liquidate positions in that country’s stock market, then send the capital to a more stable and economically developed nation.
Another example is a big move in credit markets by selling bonds from one nation to buying the sovereign debt to another, safer country. The same flight to quality can occur in the foreign exchange market, when one nation’s currency looks considerably less safe than a stable currency like the U.S. dollar. These sorts of flight to quality can often occur simultaneously as foreign capital decides to move to a safer nation to invest.
The flight to quality is an incisive way of describing market conditions and understanding the motivation of investors.