The origin of LYONs: A case study in financial innovation

Abstract

Viewed at a distance and with scholarly detachment, financial innovation is a simple process. Some kind of “shock”—say, a sudden increase in interest rates volatility or a significant regulatory change – is introduced into the economic system. The shock alters the preferences either investors or issuers in such a way that there then exists no financial instrument capable of satisfying a newly-created demand. Observing the unsatisfied demand, an entrepreneur moves quickly to seize the opportunity by creating a new financial instrument. In the process, the entrepreneur reaps an economic reward for his efforts, investors and issuers are better served, and the entire economic system is improved.

On closer inspection, however, the actual process of financial innovation turns out, like most other human endeavors, to be a lot less tidy than economists’ models would have it. In this article, we provide an “up-close” view of the origin and evolution of one financial instrument—the Liquid Yield Option Note (LYON).

The LYON is a highly successful financial product introduced by Merrill Lynch in 1985. Between April 1985 and December 1991, Merrill Lynch served as the underwriter for 43 separate LYON issues, which together raised a total of $11.7 billion for corporate clients. LYON issuers include such well-known firms as American Airlines, Eastman Kodak, Marriott Corporation, and Motorola. In 1989, other underwriters entered the market and have since brought an additional 13 LYON-like issues to market. In the words of a recent Wall Street Journal article, the LYON is “one of Wall Street's hottest and most lucrative corporate finance products.”1

As academics examining a new security, we begin by posing the questions: What does the LYON provide that was not available previously? Does the LYON really increase the welfare of investors and issuers, or is it simply a “neutral mutation”—that is, a now accepted practice that serves no enduring economic purpose, but is sufficiently harmless to avoid being extinguished by competitive forces.2

In the spirit of full disclosure, however, we must admit that we are not entirely disinterested observers. Our association with the LYON is longstanding. When the early LYON issues were being brought to market in April 1985, questions arose about LYON pricing. We were hired by Merrill Lynch to develop a model for analyzing and pricing this new financial instrument. A by-product of this assignment was the opportunity to learn about the train of events that led to the creation of the LYON, and we have since followed the evolution of this market with interest. In the pages that follow, we relate what we have observed, thought, and contributed during the development of this new security.

The LYON is a complex security. It is a zero coupon, convertible, callable, and puttable bond. None of these four features is new, it is only their combination that makes the LYON an innovation. These general features of the instrument are perhaps best illustrated by considering a specific issue. Because it was the first one, we consider the LYON issued by Waste Management, Inc. on April 12, 1985.

According to the indenture agreement, each Waste Management LYON has a face value of $1000 and matures on January 21, 2001. There are, by definition, no coupon interest payments. If the security is not called, converted, or redeemed (i.e., put to the issuer) prior to that date, and if the issuer does not default, the investor will receive $1000 per bond. If this turns out to be the case, moreover, and based on an initial offering price of $250 per bond, the investor will receive an effective yield-to-maturity of 9%.

To address that question, it is useful to trace the history of the LYON. This history begins with Merrill Lynch and Mr. Lee Cole. During the mid-1980s, Merrill Lynch was the largest broker of equity options for retail (i.e., noninstitutional) investors. During that period, owing to the success of its Cash Management Accounts (CMAs), Merrill Lynch was also the largest manager of individual money market accounts. Individuals had over $200 billion invested in CMAs. CMAs are funds invested essentially in short-term government securities and, for this reason, are subject to little interest rate risk and virtually no default risk.

During 1983, Lee Cole was Options Marketing Manager at Merrill Lynch. Cole discerned (or, more aptly, divined) a pattern in the transactions of individual retail customers. As Options Marketing Manager, Cole observed that individuals’ primary activity in the options market was to buy calls on common stocks. The most active calls had a maximum term to maturity of 90 days and often expired unexercised. Viewed in isolation, this strategy appeared to be very risky.

In reviewing customers consolidated accounts, however, Cole observed that many options customers also maintained large balances in their CMA accounts while making few direct equity investments. From these observations, Cole deduced a portfolio strategy: Individuals (or at least some individuals) were willing to risk a fraction of their funds in highly volatile options as long as the bulk of their funds were largely safe from risk in their CMA accounts. They also avoided direct equity investment. He leaped to the further inference that funds used to buy options came largely from the interest earned on CMA accounts. In short, individuals were willing to risk all or a fraction of the interest income from their CMAs in the options market so long as their principal remained intact in their CMA account.

With these observations and deductions in hand, Cole drafted a memorandum describing in general terms a corporate security that would appeal to this segment of the retail customer market. In drafting his memo, Cole's intent was to design a security that would allow corporations to tap a sector of the retail market whose funds were currently invested in government securities and options. The security described therein eventually turned into the LYON. Because it is convertible into the stock of the issuer, the LYON effectively incorporates the call option component of the portfolio strategy perceived by Cole. Because of the put option, the investor is assured his principal can be recovered by putting the bond back to the issuer at pre-specified exercise prices. The LYON thus approximates the features of the trading strategy as perceived by Cole.

If Cole's theory were correct, the LYON would be a desirable security for individual investors and would give corporation issuers access to an untapped sector of the retail market. As with most theories, however, Cole's rested upon a number of unproven assumptions. The ultimate question, of course, was whether the security would pass the market test.

It takes two sides to make a market. And while Cole had identified what he perceived to be a demand by investors, that demand could not be satisfied by every issuer. The ideal issuer would have to satisfy at least two, and perhaps three, criteria: First, because of the put feature and the downside protection desired by investors, issuers would have to have an investment-grade bond rating—and the higher the rating the better. At the same time, however, the issuer's equity would have to exhibit substantial volatility, otherwise the security would not provide the “play” desired by option investors. These two features were critical. Because the initial target market for the security was to be individuals, a third highly desirable characteristic of the issuer would be broad name recognition.

Beginning in mid-1984, the investment banking department of Merrill Lynch began the search for the first LYON issuer. That task turned out not to be a simple one. First, the population of candidates was obviously limited to those firms that needed to raise funds. Second, every issuer, even those issuing already tried and true securities, is anxious about the possibility that an issue might “fail.” That anxiety is compounded when a new instrument is proposed—especially one as complex as the LYON. Third, because investment-grade credit ratings tend to be assigned firms with less volatile earnings (and thus, presumably, less volatile stock prices), the subset of companies with investment-grade ratings and volatile stock prices is a fairly small one.

After repeated presentations to a variety of potential issuers and after repeated rejections, Waste Management, Inc. expressed an interest in the security and authorized Chuck Lewis and Thomas Patrick, the Merrill Lynch representatives, to move forward with a proposal. Furthermore, Waste Management exhibited most (perhaps all) of the requisite characteristics of the ideal issuer. Its debt was rated Aa. In terms of volatility, the annual variance of its common stock of 30% placed it in the top half of all NYSE stocks. The only question was whether Waste Management had sufficient name recognition to attract Merrill Lynch's retail customers.

Its stock was traded on the NYSE and it operated in communities throughout the country. It specialized in the disposal of industrial and household waste; but it was not necessarily a well-known consumer product. The Waste Management name was by then a familiar one, however, to the extensive Merrill Lynch brokerage network. Over the period 1972 through 1985, Merrill Lynch had managed four separate new equity issues for Waste Management, a number of secondary equity issues, and nine issues of industrial revenue bonds. All of these raised the broker and customer awareness of the company.

Over the same 1972–1985 time period, Merrill Lynch had also arranged a private placement of $50 million in debt for Waste Management and had represented the company in two hostile takeovers. This working relationship may have been the key factor necessary to overcome “first-issuer anxiety.”

In any event, Merrill Lynch finally brought the first LYON to market in April 1985, roughly 2 years after Lee Cole drafted his outline memorandum. The issue sold out quickly and Cole turned out to be at least partly right. In the case of a traditional convertible bond issue, roughly 90% of the issue is typically purchased by institutional investors with only a tiny fraction taken by retail customers. In the case of the first LYON, approximately 40% was purchased by individual investors. Apparently Merrill Lynch had designed a corporate convertible that appealed to an otherwise untapped sector of the market.

And the appeal of the LYON to the retail sector of the market has persisted. For example, Euro Disney raised $965 million with a LYON issue in June 1990. Of that issue, 60% was purchased by individual investors and 40% by institutions. Individuals accounted for over 45,000 separate orders. Over time, the fraction of LYONs purchased by retail customers has varied from issue to issue, but has averaged roughly 50% of the total. Furthermore, the zero coupon, puttable, convertible bond apparently has staying power. Of the total proceeds raised through convertible bonds during 1991, roughly half were zero coupon, puttable convertibles.

Merrill Lynch, moreover, as the entrepreneurial source of this successful innovation, has profited handsomely from the LYON. In the case of the typical convertible bond, the underwriter's spread is about 1.7% of the dollar amount of funds raised. For the earliest LYONs, the spread was 3% and, at the present time, continues to be about 2.5% of the amount of funds raised. Additionally, Merrill Lynch was able to “corner” the market for almost 5 years before other investment bankers brought LYON-like securities to market. According to the Wall Street Journal article cited earlier, since 1985 Merrill Lynch has earned some $248 million from sale of LYONs.

It was only after the Waste Management LYON had been brought to market successfully that Merrill Lynch asked us to build a model to value the security. Why the need for a model? The answer has as much to do with marketing as with the need of traders and issuers to analyze and price the security. The answer is also reassuring to those like us who view modern finance theory as a powerful, but practical, scientific discipline with important implications for corporate managers and investors.8

Following the issuance of the Waste Management LYON, Merrill Lynch intensified its effort to bring additional issues to market, both to increase the liquidity of the market for the security and to demonstrate that the security was not just a passing curiosity.9 Following the success of the first LYON, other potential issuers showed more interest, but also asked more questions.

Three questions typically came up: First, what was a “fair” price for a specific LYON given the characteristics of the company and security in question?10 Second, how would the security react under different market conditions? Third, under what conditions would investors elect to convert the security to common stock? This last question was asked by managers concerned about the dilutive effect of conversion on the company's EPS.

It is difficult to generalize from a single observation—and the LYON is just one of many successful financial innovations of the 1980s. The case history of the LYON does illustrate, however, that successful financial innovation requires ingenuity, perseverance, and, perhaps, a measure of good fortune. It also illustrates the potential practical power of modern financial theory in assisting in the development of new financial products and strategies. As practitioners of the science of modern finance, we were fortunate enough to be present at the creation of what now appears to be a successful financial innovation.