Economic Policy Uncertainty and Corporate Bond Liquidity

We find elevated Economic Policy Uncertainty (EPU) is associated with reductions in corporate bond dealer inventories and worsening liquidity, suggesting bond dealers react to increased inventory risk by reducing their capital commitments and compensating themselves via increased transaction costs. A one standard-deviation increase in EPU is associated with a 1.83% widening in bid-ask spreads, 3.06% increase in Amihud illiquidity and 1.33% reduction in average inventories. This effect is less pronounced in small firms, speculative-grade bonds, illiquid bonds, and calmer markets, suggesting that EPU affects bond liquidity more when macroeconomic –not idiosyncratic – factors are the primary determinant of a bond’s risk