A capital note is a short-term debt instrument (security) mainly issued by a corporation to pay off short-term obligations that are due in less than one fiscal year.
Since capital notes are unsecured fixed-income securities, an investor bears a high level of risk from buying the notes. Capital noteholders are the least priority among all debtholders of the enterprise. In other words, in the event a company goes bankrupt, capital noteholders (also debtholders since it is a debt instrument) will be repaid last after all other debtholders are compensated for the default.
How Does a Capital Note Work?
Investors loan money to an issuer by purchasing its capital notes for a particular period. The issuer, in return, promises to make periodic interest payments until the maturity of the note. The principal of the note is repaid to capital noteholders at the maturity date.
Since capital notes are high-risk debt securities, investors usually claim a higher interest rate as compensation for the level of risk.
Capital notes are usually not callable in addition to high coupon rates being paid to the noteholders. It means that an issuer is not allowed to call back the notes (repurchase them) during the life of the notes.
However, it does not guarantee that the issuer will be paying interest until maturity since it might redeem the notes.
Interest Rates on Capital Notes
Interest rates vary across borrowers. In essence, they are dependent on the credit ratings of companies that issue capital notes. As far as investors are concerned, a credit rating is everything they can rely on while making investment decisions.
Unsecured debt means that there is no collateral in place to secure a loan. In other words, there is no asset to be pledged against the loan so that if a borrower defaults, the lender can repossess the collateral (the asset) and sell it off at a fair price in the open market to return the loaned money.
An unsecured note is a type of subordinated debt, and thus, it is ranked below secured notes issued by the borrowing entities.
Capital Note vs Convertible Note
The main difference between capital notes and convertible notes is that the latter can be converted into a known amount of equity in a company later on. Both notes are short-term unsecured debt instruments.
Convertible noteholders are angel investors investing in new companies (startups) that imply a high level of risk because no one knows which startup will succeed.
What is a Bank Capital Note?
A bank capital note is a note issued by a bank to raise funds for short-term financing issues, e.g., the need to meet its minimum capital requirements. Banks are highly regulated bodies, and they must maintain a minimum amount of capital in reserve to function properly as a financial institution.
So, capital notes are used to account for the short-term financial issues of banks. It is important to mention that bank capital notes do not come with a fixed maturity date, meaning there is no due date for a bank to repay the loan.
Banks decide whether they would be paying interest or not. Moreover, they can reduce the initial amount of interest or stop paying it temporarily or permanently.