Flight to Quality: Understanding Safe

Havens

As we have seen protecting capital becomes the

goal in extreme risk-off conditions where fear has
started to infiltrate the market mood.

The term ‘flight to quality’ is used to describe the

movement of capital within a financial market to
investments considered as relatively lower risk.

Those assets which are considered risky therefore

become undermined by fear within the markets,
causing investors to look for investments which
will provide security, albeit with a significantly lower yield.

Flight to quality occurs when financial markets become nervous about current or future events which
may affect the value of investments categorized as riskier assets. Risky assets are generally defined as
those which do not guarantee a return to investors. They are also generally higher-yielding and
potentially more volatile than those investment vehicles which grow in popularity during market
uncertainty. Within this category, stocks, commodities and currencies can all be considered as risky
assets, although within these groups there are also those assets which are considered higher and lower
risk to investors.

During periods of market stability and high investor-confidence, riskier assets are seen as a way to
capitalize on the opportunities provided by positive market conditions. Further examples of this would
be strong employment figures fuelling a bull market where stock values are rising, and individual retail
assets are seen as highly attractive investments.

Similarly, the raising of interest rates to cool a runaway market in

an emerging economy will encourage investors to speculate on Low liquidity means that it might be
the rising value of a minor currency. These assets would be difficult to find a buyer for the asset
considered risky for two main reasons; primarily the fact that they you want to sell. This provides a risk
are subject to volatility related to investor-confidence and, that the price of the asset might
secondly, since they may be considered to be low-liquidity assets. move in either direction before you
could sell it.
Combining these two factors means that, should uncertainty
occur, the value of these assets has the potential to decrease
substantially and the low liquidity makes them potentially difficult to dispose of.

Quality assets can be defined as those investment vehicles which are seen as stable, or at least
historically able to withstand, international market uncertainty.

Within this category, there are those assets which provide a guaranteed return, such as Government
bonds and those assets which are seen to have intrinsic or global value.
In a flight to quality scenario, investors may move their capital to the government treasury of a powerful
economy, via bonds, to gain the small but guaranteed yield. Alternatively, they may invest in the
international ‘safe havens’ of gold or the US Dollar to protect their capital.

Since gold is considered to have an intrinsic value, and the US dollar is the global reserve trading
currency, investors are confident in the quality to preserve their investment capital.

There are broadly three reasons why flight or shift to quality occurs.

1. The first of these is related to international market uncertainty where large number of
investors channel their capital in to non-risky assets during periods where future asset value is
considered as under threat.
2. There is also move to quality when investors place some of their capital into quality assets in
the diversification of individual portfolios. This diversification is often unconnected to the
sentiment within the international financial markets and is a way for investors to spread the
risk across multiple asset classes.
3. Finally, individual events may cause temporary volatility which in turn leads to a flight to quality.
Examples of these events would be the reduction in an interest rate from a previously high-
yielding currency or the outcome of an election in an emerging economy. Whilst these events
can occur on a national basis the mood can easily spread throughout these closely connected
international markets

Summary

1. Safe havens are sought when the need to protect capital outweighs the thirst for return
on investment
2. Gold is a strong example as it has no yield at all.
3. As traders we are mostly interested in the macro events that shift risk conditions and
offer opportunities in high probability asset classes.