Merton model’s prediction and empirical evidence on bond and equity prices reaction to new bond issues

I use the Merton model as a theoretical framework to assess 1) the expected impact of a new bond offering on existing bond and stock prices, and 2) how the bond and stock price reactions are conditioned on characteristics of the new and existing bonds and the planned use of the new funds. Consistent with the Merton model prediction, I find negative and significant average abnormal returns of issuers’ existing bonds over a three-day event window surrounding the announcement of new bond issues. In contrast, average abnormal stock returns of the issuing firms are positive but insignificant. Bond market announcement returns estimated using daily corporate bond data from TRACE are more negative for longer-term outstanding bonds and less negative when the new bonds are junior to existing bonds. I also find that the bond price reaction (stock price reaction) is more negative (less positive) when funds are to be used for expansion than when they are to be used to repurchase stock.