Learning To Read Between The Lyo Ns

The Internal Revenue Service's recent decision to drop a challenge to Liquid Yield Option Notes removed any threat to this hybrid investment vehicle. LYONs are now more popular than ever--but are they a good deal for investors?

Invented by Merrill Lynch in 1985, LYONs represent a cross between zero-coupon and convertible bonds. Like zeros, LYONs sell at a deep discount to their $1,000 face value and make a onetime, lump-sum interest payment at maturity--usually in 15 or 20 years. Current yields to maturity average 7.47%.

But like convertible bonds, LYONs can be exchanged for a fixed amount of the issuing company's stock. So investors can profit from a rise in share price. And if the stock drops, you still make money by holding on to the bond and collecting the principal and interest at maturity. You can also cash in a LYON for a preset value at "put" dates every five years or so--giving you an out before the maturity date. But the company can pay the puts in stock or notes instead of cash.

It's easy to see why Walt Disney, Seagram, Marriott, and others issued LYONs. They can pay a lower rate than on regular bonds, in exchange for the conversion feature. And they can write off the interest each year, even though they don't actually pay any until maturity.

UNLIKELY EVENT. WhetherLYONs make sense for investors is less clear. LYONs are "easy to sell but very difficult to evaluate," says John Markese, research director at the American Association of Individual Investors.

Although the conversion feature is a big selling point, investors may never be able to use it, says Alan Lyons, editor of financial newletter Value Line Convertibles. LYONs are sold at an initial premium over the common-stock price. Their value increases by the accrued interest every year. But the number of shares remains fixed. So the underlying stock has to rise a lot more than the rate on the bond to make a conversion worthwhile. Lyons cites Sonat, an oil-and-gas company that issued $575 million worth of LYONs in 1990. Each LYON sold for $343--a 15% premium over the bond's conversion value of $299 (5.77 shares trading at 51 3/4 on the issue date). After five years, the bond would be worth $487 (five years of interest at 7.25%). But you still can exchange it for the same 5.77 shares. So the stock would have to rise more than 63% to convert profitably.

Another pitfall: Companies can call their LYONs if interest rates drop. Last year, Merrill Lynch left investors in the lurch by calling $618 worth of LYONs yielding 8% due to mature in 2006. The broker was able to borrow at lower rates, proving thatLYONs can bite the hand that feeds them. Pam Black