Lender Learning and the Public Equity Market

Abstract

We examine whether private lenders learn from the equity market. We conjecture that lenders can learn new information from stock prices about firms’ fundamentals and growth opportunities (prospects channel) or managers’ incentives to take risky actions that may be detrimental to the value of debt claims (incentives channel). Exploiting the mergers and acquisitions (M&A) setting, we find a V-shaped relation between M&A announcement returns and the interest spread on loans issued following M&As. We further show that the association between announcement returns and the interest spread is more pronounced when managers’ risk-taking incentives are likely to be more acute. These findings suggest that lenders learn from stock prices in assessing borrowers’ creditworthiness and that this learning works, at least partially, through the incentives channel. Our evidence highlights a novel channel through which firm stakeholders with incentives misaligned with those of stockholders can learn from stock returns.