What is Flight to Quality?A flight to quality is the act of moving capital away from 'risky' investments and toward 'safer' investments due to uncertainty about the overall economy.
How Does Flight to Quality Work?Anything that increases uncertainty in the markets can cause a flight to quality . Slower-than-expected economic growth, corporate scandals, wars, high oil prices, and other factors can convince investors that markets are about to slow or fall.
For example, if in the past few months a lot of negative news has come out on the domestic economy, many investors may sell their riskier growth stocks (usually with lofty valuations) and purchase safe Treasuries in order to avoid losing capital.
Although a flight to quality can affect all investment sectors, it might occur in just one market sector, such as the bond market (where investors would sell junk bonds and invest in Treasuries or high-grade corporate bonds) or the stock market (where investors sell their aggressive growth stocks and buy safer blue-chip stocks). An international flight to quality might also occur, whereby investors sell their investments in a risky foreign country and reinvest in a safer country.
Why Does Flight to Quality Matter?Two instruments receive a lot of attention during a flight to quality : blue-chip stocks and Treasuries. Investors often flee to blue-chip or defensive stocks because they usually deliver good earnings even in weak economic times. These stocks may offer lower returns in the long run, but they compensate for this with less risk of loss.
Treasury securities also often receive significant investment when a flight to quality occurs because Treasuries are generally considered risk-free assets. Thus, a dramatic drop in Treasury yields (due to a big increase in demand for them) is one way to tell whether a flight to quality has occurred. Also, quality blue-chip stocks would perform surprisingly well relative to the broader stock market when there is a flight to quality.
To learn more from our top expert on income investing, click here for Carla Pasternak's explanation of why U.S. Treasury Bonds Offer Stable Returns in Difficult Markets.