Know When to Hold Them, Know When to Fold Them: Dealer Behavior in Highly Illiquid Risky Assets

This study examines dealer behavior in a sample of 14,749 corporate bonds that vary in credit rating and liquidity. Our unique data set allows us to identify purchases and sales by individual dealers, enabling us to determine how long a dealer holds a bond purchase in inventory and how much of that initial purchase the dealer sold to customers, and the spread on those sales to customers, and how these vary with credit rating and liquidity of the bond in the past 30 days. We examine 1,477,286 different institutional size purchases by individual dealers and their subsequent sales across 14,749 bonds from August 7, 2002 to July 31, 2008. We find that as dealers holding periods do not necessarily decline as liquidity increases; in fact, dealer’s holding periods for some of the most illiquid bonds (with trades less often than once every three days) are shorter than those bonds that trade five times a day or more. Dealers are also more likely to sell all of their purchase for the less liquid bonds. These effects become stronger as credit quality decreases. Interestingly, previous liquidity or illiquidity has little effect on the spreads dealers charge customers. _________________________________________________________________ The authors are indebted to David Pedersen for extensive research assistance. We thank seminar participants at The Queen’s University – Belfast. PRELIMINARY DRAFT: PLEASE DO NOT CIRCULATE WITHOUT AUTHORS’ PERMISSION 2 Know When to Hold Them, Know When to Fold Them: Dealer Behavior in Highly Illiquid Risky Assets