What is a Liquid Yield Option Note (LYON)?

Last Updated: 30 Jun 2022

The financial market is one of the best places to invest money and multiply wealth over time. However, as there are numerous financial instruments where a person can invest, it becomes confusing to choose. Experienced investors diversify among a few to ensure they are better equipped to manage risks and continue to make profits even if one asset class is going through a bear phase. One of the most important asset classes chosen by experienced investors is Bonds, and within it, they invest hugely in a one of its kind hybrid bond called liquid yield option note.

What are Bonds?

Bonds are loan agreements between the issuer and holder, which details payment terms (debt servicing) and maturity. These come with a face value (principal) to be repaid on maturity and can be issued either at a discount or a premium.

Bonds are fixed tenure debt instruments issued to finance specific projects by the issuer. The interest (based on coupon rate) is paid in pre-defined instalments to the bondholder until maturity. Bond prices are inversely proportional to market interest rates and depend on various factors such as the issuer’s credibility, maturity, and interest rates in the market.

About Liquid Yield Option Note (LYON)

A liquid yield option note (LYON) is a hybrid bond that is a form of zero-coupon convertible bond and allows the issuers or the bondholders to convert the note into a predetermined number of company shares. A zero-coupon convertible bond is a type of bond that pays no interest to the bondholder and is issued at a discount to par value. The liquid yield option note (LYON) was first introduced in the year 1985 by Merrill Lynch to provide risk protection to the issuers and the bondholders.

Understanding liquid yield option note (LYON)

The liquid yield option note (LYON) was established as a fixed instrument to combine the features of a zero-coupon bond with the features of a convertible bond. With the features of the zero-coupon bonds, the liquid yield option note (LYON) pays no interest to the bondholders and is issued at a discount at par. On the other hand, the features of convertible bonds allow the bondholder to convert it into the company’s common stock at a predetermined conversion price.

Liquid yield option notes (LYON) are callable and putable bonds. Being callable allows the issuer of the liquid yield option note (LYON) to buy them back before expiration, while the putable option allows the bondholder to sell them before the expiration. When first introduced, they were referred to as financial innovations because of the callable and putable options. Furthermore, the liquid yield option note (LYON) is a synthetic financial instrument that mirrors the cash flow of other financial instruments. It is done by providing the flexibility of converting the bonds into a specific number of the underlying company’s shares. The put option allows the bondholders to force the issuer of the bonds to repurchase them at a specific date before maturity.

Liquid yield option note (LYON) Issuer

Any corporation can issue a liquid yield option note (LYON) with the promise that the bondholder has the right to convert their liquid yield option notes (LYON) into common stocks of the company. Once the bondholders convert the liquid yield option notes (LYON) into common stocks, they are entitled to all the rights as a shareholder, including dividend payments.

Final Words

The liquid yield option notes (LYON) benefit both the issuers and the bondholders and give the investors a regular flow of income if the bond is zero-coupon. The combination of put and call options effectively reduces the short-term interest risk that the issuers (corporations) and bondholders undertake.

The main aim of the liquid yield option notes (LYON) is to limit underinvestment, asset substitution, and claim dilution. However, it is vital to analyse and understand the type of corporation issuing the liquid yield option notes (LYON). They should be financially stable with good credibility to repurchase the bonds. Now that you know the liquid yield option note definition, you can make an informed investment decision to diversify and limit your losses.