Dealer Inventory and the Cross-Section of Corporate Bond Returns

Abstract

Inventory models of dealership markets imply that intermediaries reduce their exposure to inventory risk by offering prices different from fundamental values. Therefore, inventory levels should affect asset prices and thus returns. We explore the cross-sectional relation between US corporate bond inventories and returns. Our findings provide strong support for the asset pricing implication of inventory models, that is, the risk-adjusted return of a high-minus-low inventory-sorted portfolio is 21 basis points per week. Furthermore, we examine several drivers of the inventory risk premium; for example, we emphasize the importance of inventory risk sharing in pricing bonds.

Keywords: US corporate bond market, OTC market, dealer inventory, cross-sectional asset pricing, risk sharing

JEL Classification: G10, G12, G20