Two intermediary-based factors – a broad financial distress measure and a dealer corporate bond inventory measure – explain about 50% of the puzzling common variation of credit spread changes beyond canonical structural factors. A simple model, in which intermediaries facing margin constraints absorb supply of assets from customers, accounts for the documented explanatory power and delivers further implications with empirical support.
First, whereas bond sorts on margin-related variables (credit rating and leverage) produce monotonic patterns in loadings on intermediary factors, non-margin-related sorts produce no pattern. Second, dealer inventory co-moves with corporate-credit assets only, whereas intermediary distress co-moves even with non-corporate-credit assets. Third, dealers’ inventory increases, and bond prices decline, in response to instrumented bond sales by institutional investors, using severe downgrades (“fallen angels”) and disaster-related insurance losses as IVs.