Search friction, liquidity risk, and bond misallocation

Search friction is a key driver of changes in corporate bond yield spreads over time. In the cross-section, the liquidity risk stemming from search friction is significantly priced, and is strongly correlated with the misallocation of bond positions among different traders. I propose a novel measure of bond-specific misallocation, which is the negative covariance between traders’ private valuations and their inventory positions for each bond. I find that bonds with higher levels of misallocation are associated with lower absolute levels of liquidity risk from search friction. I develop a search-and-matching model to explain this correlation.