Financial Leverage and Stock Return Comovement

Abstract

We find that leverage-initiating stocks experience an increase in return comovement with existing leveraged stocks and a decrease in return comovement with existing zero-leverage stocks in the year after the leverage initiation event. In contrast, stocks that fully deleverage comove more with their new peers of zero-leverage stocks and less with their old peers of leveraged stocks. These findings are robust after controlling for common factors and firm characteristics and using various time series and events as exogenous shocks to corporate leverage decisions. The shifts in return comovement are greater for larger absolute leverage changes and distinct from the dividend clientele effect. Our findings can be explained by the financial leverage clientele effect. We find that mutual funds adjust their holdings of leverage changing stocks around the event year and that funds have a propensity to invest their capital flows according to their investors’ preference for leveraged (zero-leverage) stocks.