Flight to Quality and Flight to Liquidity as Factors in Bond Pricing

Illiquidity and default risk are determinants of bond spreads that models suggest vary across the term structure and across market states. But existent attempts to empirically identify the separate impact of these factors are affected by correlation between them. The Australian sovereign debt market, where the Australian government provided an explicit guarantee over semi-government debt, provides a clean environment in which to examine these separate factors. Using this clean environment, we find that the illiquidity premium is conditional upon market states and particularly important during periods of market stress. We also show that the short end of the term structure premia is explained by illiquidity risk while the long end is explained by market volatility. Spreads at the short end of the term structure are more sensitive to illiquidity shocks than those at the long end.