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.
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