Bond Liquidity and Corporate Cash Holdings

Motivation: This paper is motivated by the fact that asset liquidity is important in asset pricing and has significant implications for corporate investments. Premise: This paper attempts to fill the gap in the literature by investigating the impact of bond liquidity on corporate financial policies. Approach: We exploit two exogenous bond liquidity shocks, namely, the inception of the trade reporting and compliance engine (TRACE) and Lehman bankruptcy filing, as well as the traditional measures of bond illiquidity to establish the causal relation between bond liquidity and corporate cash holdings. Results: This study demonstrates that bond illiquidity has a causal positive effect on corporate cash holdings. Additional analysis suggests that bond illiquidity increases the value of cash, and this effect is more pronounced for financially constrained firms. Conlusion: Our findings are consistent with the view that because bond illiquidity hinders firms' access to the external debt market and hence increases the cost of debt, they maintain larger cash holdings to mitigate underinvestment. Consistency: Our results are of interest to regulators who may formulate rules to regulate bond liquidity and practitioners as they make decisions on corporate liquidity and investments.