Search Friction, Liquidity Risk and Bond Mis-allocation

Abstract

Systemic search friction is an important liquidity factor which drives all corporate bonds' yield spread changes. In cross section, bonds have different levels of this yield spread loading. To explain this cross-sectional heterogeneity, we propose a measure of bond-level misallocation among traders, which is defined as the covariance of traders' private valuation and inventory position for each bond. Using transaction-level data, we find that: bonds with a higher level of misallocation have a lower absolute value of yield spread loading on systemic search friction. This relationship is specific to the decentralized market structure, where transactions rely on traders’ searching activity.

Keywords: corporate bond market, bond mis-allocation, liquidity risk, search frictions

JEL Classification: G10, G12, G21