 Mergers increase safety of the bond holders by increasing the value of their bonds, but it hurts the stockholders. Although mergers allow for diversification, which in turn reduces the volatility in the value of the combined firm, more than volatility is in the sum of the values of the individual firms participating in the process of merger. To understand this decrease in the volatility, let take an example as a base case where we have two firms, firm A and B and the acquirer is the firm A who is acquiring the firm B. There are pre-merger two states with equal probabilities of 50% each. So if we see in the red box where the combined firm's market value is 75 dollars assuming no synergy effect and B's stockholders receive stock in the new firm titled as AB equal to the B's standalone market value of 25. This means that if B's shareholders are compensated for the merger in the stocks of the new firm, then the value of the new firm's stock is exactly equal to the value of the B firm's stock at present. The A's post merger value is 50 dollars and this is basically the difference between the value of the combined firm which is 75 dollars and the value of the stock given to the shareholders of B which is 25 dollars. So it leaves nothing for the firm A as well. So we see that the both firms A and B's stockholders are indifferent in this merger attempt because after merger the value of their holdings is equal to the value of their holdings which is pre-merger. Now we use the case of debt and here we see again two states. We see that if A is default in state two its debt has market value of 20 dollars. So the bondholders of firm A will receive only 20 dollars. In this case the A's average value is 25 dollars whereas if B gets a default in situation A or state one, its debt market value is 10 dollars. Its bondholders will receive only 10 dollars leaving the market value of the firm at 12.5 dollars as the debt's market average market value. So the sum of pre-merger market value of A and B with respect to their equity and debt is a same value and that is 37.5 dollars. Now if the post merger combined value of AB firm is 75 dollars then what will be the effect of the merger on the bondholders. Let's see we see that post merger combined value of the debt is 45 dollars whereas the pre-merger value of this debt is 37.5 dollars. So there is a value enhancement in the values of the debt and that is 7.5 dollars. So bondholders are gaining but about merger's effect on the stockholders we see that post merger combined value of equity of both the firm is 30 dollars whereas pre-merger the combined value of both of the firms was 37.5 dollars. So in this situation the stockholders are losing by 7.5 dollars. So we see that the loss of stockholders in this merger attempt is equal to the gain of bondholders but the firm or the combined firm is gaining no benefit at all. So what does this transfer of value occur or how this transfer of value has occurred. See that separately B does not guarantee A's debt. After merger bondholders can use cash flows of the combined firm AB. This means that individually the debt holders of A has no guarantee from the debt holder from the owners of B firm but when both of the firms are combined in the merger the cash flows of the B can be cash flows of the combined firm which is AB can be used to pay off the debt of the firm AB. This form of mutual guarantee is generally termed as co-insurance effect. In co-insurance effect this makes the debt less risky and more valuable than before merger. The bondholders gain at the cost to the stockholders under this co-insurance effect which means that loss of the equity holders is exactly equal to the gain of the debt holders due to the non-availability of the synergy effect. Then question arises that how shareholders can reduce their loss from the co-insurance effect. See that firm A may retire its debt before merger announcements, debt and it can reissue an equal amount of debt after the merger. And this refinancing of debt retired at the low pre-merger price can utilize the effect of co-insurance to the stock hold bondholders. Similarly the new firm AB can issue more debt after the merger because of two reasons. The first is that the interest tax shield from new corporate debt will raise the combined value of the new firm AB and the post mergers increased debt will raise the probability of financial distress. Thus it will reduce the bondholders gain from the co-insurance effect