Capital Note

What Is a Capital Note?

A capital note is short-term unsecured debt generally issued by a company to pay short-term liabilities.

Capital notes carry more risk than different types of secured corporate debt, since capital note holders have the lowest priority.

Figuring out Capital Notes

Investors that purchase capital notes are loaning money to the issuer for a fixed period of time. In return, they receive periodic interest payments until the notes mature, at which point the note holders are repaid their principal investment. The capital note frequently has a higher interest rate since it is unsecured.

An unsecured debt is one that doesn't have its interest and principal payment obligations backed by collateral. Since payments on capital notes are guaranteed by the full faith and credit of the issuer, investors demand a higher interest rate for the default risk exposure that accompanies holding these fixed income securities.

In effect, the interest rate offered on a capital note is vigorously dependent on the credit rating of the business since it is all the investor needs to depend on. Moreover, an unsecured note is subordinated debt, and that means that it is positioned below secured notes issued by the borrowing firm. In the event the company becomes ruined or bankrupt, the secured noteholders will be paid first. Anything that remains from the higher prioritized distribution will be paid to capital note holders. Subsequently, why capital notes are issued with higher interest rates.

Notwithstanding the high coupon rate on capital notes, capital notes are ordinarily not callable — another feature that might draw in investors to purchase the debt instrument. A bond or note that is callable doesn't guarantee that interest payments will go on for the stated life of the bond since the issuer might reclaim the notes prior to maturity. In this manner, investors commonly favor a bond that isn't callable, as they can hope to receive the fixed interest income stipulated in the trust indenture until the bond matures.

Prior to maturity of the notes, investors might be given the option to change over their holdings into common equity at the responsible company, ordinarily at a small discount to the market price. Nonetheless, this is just an option as the investor might decide to have their principal repaid in full.

Bank Capital Notes

Banks might issue capital notes to cover short-term financing issues, for example, having the option to meet least capital requirements. Banking regulation expects banks to have a base amount of capital in their reserves to keep working. To fulfill regulatory demands with respect to capital requirements under the Basel Accords, banks will issue capital notes classified as either Tier 1 or Tier 2 capital.

Bank capital notes have no fixed maturity date. There is no set date on when the bank will repay the loan and, as a matter of fact, the investment might very well never be repaid. Assuming the bank eventually closes shop, the noteholders will be paid after undeniably secured noteholders with the bank have been paid given that the capital notes are unsecured and subordinated.

The decision to pay interest on capital notes is exclusively the bank's decision. The bank might choose to keep paying interest, reduce the interest income paid, or stop paying interest for a brief time or permanently. Since interest on capital notes is non-cumulative, on the off chance that the bank misses an interest payment, it doesn't need to pay that interest sometime in the future. This means the investor might relinquish any skipped payments on the bonds.

At long last, the bank has the prudence of changing over its capital notes into shares in the bank or the bank's parent company. In the Basel tiers system, capital notes are treated as close to equity, as the two forms of financing support the bank's capital.

Highlights

• A capital note is a type of unsecured debt a company could take to cover short-term liabilities.
• Capital notes are normally not callable, which makes them appealing to investors since they can hope to receive interest payments until the note matures.
• This likewise means the debt is junior to secured notes. Investors holding capital notes are paid behind the holders of secured notes should a company fail.
• Since the debt is unsecured, capital notes normally pay investors a higher interest rate.