Takeover risk and the correlation between stocks and bonds

Existing research suggests that, for a given firm, stock returns and bond prices are positively related, and this implies a negative relation between stock returns and bond spreads. In this paper, we show how takeover risk influences this relation. Bondholders of high-rated firms can suffer losses in a takeover, particularly if the takeover is largely funded with debt, resulting in a more positive (or less negative) correlation between stock returns and bond spread changes. Consistent with this notion and based on a large sample of data covering the period from 1980 to 2000, we find that high-rated firms which are likely to be taken over have a more positive correlation between stock returns and bond spread changes, while target firms with a poison put or an indebtedness covenant have a more negative correlation. Overall, our findings have implications for the pricing and hedging of bonds and default risk based financial products such as credit default swaps.