Baele, Lieven, Geert Bekaert, Koen Inghelbrecht, and Min Wei, “Flights to Safety,” American Finance Association 75th Annual Meeting, Boston (2015).
Purpose: To propose an empirical definition of a “flight to safety” episode, using only stock and bond return data.
Claim: A “flight to safety” (FTS) is a day on which
- Bond returns are positive.
- Equity returns are negative.
- Bond returns are negatively correlated with stock returns.
- Equity return volatility is large (markets are stressed).
- Data covers bond and equity returns for 23 countries from January 1980 through January 2012.
- In the literature, flights to liquidity may be as important as flights to quality. Therefore, this paper looks at returns on highly-liquid 10-yeargovernment bonds.
- German bonds are the benchmark for Eurozone countries; local government bonds are the benchmark for all others.
- Equity returns are indexes denominated in local currencies, from Datastream International.
- Develop a composite flight-to-safety indicator
- Sort observations by variables that are conceptually increasing in likelihood of flight to safety.
- Assign a ranking to each observation for each sort, then divide each ranking number by the total number of observations–the “ordinal numbers.”
- Identify days that qualitatively appear to be “mild” flight-to-safety episodes:
- bond returns are higher than stock returns,
- bond returns are further above their 250-day average than are stock returns,
- the short-term stock-bond correlation is negative,
- the long-term stock-bond correlation is higher than the short-term correlation (it is less negative or positive),
- equity return volatility is more than one standard deviation above its mean, and
- short-term equity volatility is higher than long-term volatility.
- Observations that fail to meet the qualitative test are given a FTS indicator of zero.
- Observations that pass the test are given an indicator of 1 minus the percentage of observations failing the test that have a higher ordinal number.
- This methodology identifies major market crashes, including October 1987, the Russia crisis of 1998, and the Lehman bankruptcy.
- In a flight to safety
- Bond returns are 2%-3% higher than equity returns.
- The Yen, US Dollar, and Swiss Franc appreciate.
- The VIX increases.
- Consumer sentiment falls.
- Money-markets, corporate bonds, and non-metal commodities have negative abnormal returns.
- Liquidity suffers in both bond and equity markets.
- Immediately following a flight to safety, economic growth and inflation decline for up to one year.