Liquid Yield Option Note (LYON)

What Is Liquid Yield Option Note (LYON)?

Liquid yield option notes (LYONs) are a form of zero-coupon convertible bonds that allows the holder or issuer to convert the note into a fixed number of company shares.

Merrill Lynch introduced the first LYON for Waste Management (WM) in 1985.

Understanding Liquid Yield Option Notes (LYONs)

A zero-coupon convertible is a fixed income instrument that combines the features of a zero-coupon bond with that of a convertible bond. Due to the zero-coupon feature, the bond pays no interest and is therefore issued at a discount to par value, while the convertible feature means that bondholders have the option to convert bonds into common stock of the issuer at a certain conversion price.

LYONs are zero-coupon convertible bonds. These bonds are also callable (which gives the issuer the right to buy them back) and putable (which gives the holder the right to sell them back). These three qualities and the fact they offer no coupons made them a financial innovation when first introduced.

LYONs are considered synthetic instruments. Being a synthetic vehicle means they have a structure that simulates the cash flow of other financial instruments. The convertible feature allows them to be converted into a predetermined number of the underlying company's shares at certain times during the bond's life, usually at the discretion of the bondholder. The put nature of the LYON allows the bondholder to force the issuer to repurchase the security at specified dates before maturity. The repurchase price is set at the time of issue and is usually at par value.

Special Considerations

While the convertible and put features award the investor, the callable feature awards the issuer. A callable bond is one that can be called for redemption by the issuer before it matures. Issuers generally do this when interest rates dip and they can save money by redeeming bonds immediately. When this happens, the bond will pay a pre-determined price based on its current age.

The zero-coupon LYON will not give the investor a regular flow of income. A zero-coupon bond is a debt security that doesn't pay interest or coupon. It is usually offered at a deep discount and renders its profit at maturity with redemption at full face value.

Liquid Yield Option Note Issuers

Merrill Lynch engineered and served as the primary underwriter for LYONs. An investor choosing to convert their LYON to common stock would receive shares of the bond's issuer. Once the conversion of a LYON to stock is complete, the holder is entitled to all of the rights and dividends of a regular stockholder in that company.

In addition to Waste Management, some well-known companies that issued LYONs through Merrill Lynch include Eastman Kodak, American Airlines, Motorola, and Marriott.