Liquidity Supply in the Corporate Bond Market

Abstract

This paper examines dealer inventory capacity, or liquidity supply, as a driver of liquidity and expected returns in the corporate bond market. We identify shocks to aggregate liquidity supply using data on corporate bond yields and dealer positions. Liquidity supply shocks lead to persistent changes in market liquidity, are correlated with proxies for dealer financial constraints, and have significant explanatory power for cross-sectional and time-series variation in expected returns, beyond standard risk factors. Our findings point to liquidity supply by financially constrained intermediaries as a main driver of market liquidity and asset prices.