Asset Illiquidity and Financial Conditions -- An Examination of the U.S. Corporate Bond Market

Abstract

Using the lead underwriter of a bond issue as a proxy for the market maker of the bond and credit default swap (CDS) as a measure of financial conditions, this paper shows that a bond’s liquidity is positively related to the financial conditions of its market maker. In particular, controlling for other bond characteristics and market wide liquidity, bonds whose market makers CDSs are higher are less liquid, and the difference in bond illiquidity between the most and the least financially-constrained market makers is much larger during the 2008-2009 liquidity crisis. In addition, the paper also shows that the liquidity of bonds that share the same market maker tends to co-move together, even after controlling for the overall market liquidity. This co-movement is the strongest during the 2008-2009 crisis periods. The empirical evidence highlights the role of a market maker’s financial constraints in an asset’s liquidity and provides consistent evidence for the link between market liquidity and funding liquidity.