We use a unique dataset of corporate bonds guaranteed by the full faith and credit of the U.S. to test a number of recent theories about why asset prices may diverge from fundamental values. These models emphasize the role of funding liquidity, slow-moving capital, the leverage of financial intermediaries, and other frictions in allowing mispricing to occur. Consistent with theory, we find there are strong patterns of commonality in mispricing and that changes in dealer haircuts and funding costs are significant drivers of mispricing. Furthermore, mispricing can trigger short-term margin and funding-cost spirals. Using detailed bond and dealer-level data, we find that most of the cross-sectional variation in mispricing is explained by differences in dealer funding costs, inventory positions, and trading liquidity measures. These results provide strong empirical support for a number of current theoretical models.
We are grateful for the comments of Dan Covitz, Yesol Huh, Sebastian Infante, Dan Li, and seminar participants at the Federal Reserve Board and UCLA. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Federal Reserve Board. All errors are our responsibility. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Francis A. Longstaff
The only source of financial support for this research was my regular salary as a UCLA Faculty Member. No outside financial support for this research was received. No other party had the right to review the results of the paper prior to publication.
In the past three years, I have worked/consulted for the UCLA Anderson School, University of California at Berkeley, Blackrock, PIMCO, Simplex Holdings, CALPERS, Fidelity, and Structured Portfolio Management.