Middlemen Matter: Corporate Bond Market Liquidity and Dealer Inventory Funding

Abstract

Corporate bond dealers build up considerable inventories for which they rely on short-term funding. I provide empirical evidence that dealers' inventory financing constraints are a crucial determinant of the costs of their liquidity provision in corporate bond markets. Constructing a unique dataset that links dealer identities with transaction prices, I show that dealer-specific financing constraints (as proxied by their CDS spreads) explain a substantial part of the variation in the inventory cost component of the effective bid-ask spread. Compared to low volatility bonds, the liquidity provision of high volatility bonds is more sensitive to inventory costs, especially during periods of funding stress. Finally, exploiting a quasi-natural experiment, I show that the relaxation of funding constraints through a Federal Reserve emergency credit facility temporarily alleviates liquidity problems among eligible dealers.

Keywords: Dealer Behavior, Effective Bid-Ask Spread, Inventory Cost, Liquidity, Corporate Bonds, Financial Crisis

JEL Classification: G01, G12, G18, G22, G24