DEFINITION of 'Capital Note'

Capital note is short-term unsecured debt generally issued by a company to pay short-term liabilities. Capital notes carry more risk than other types of secured corporate debt, because capital note holders have the lowest priority.

BREAKING DOWN 'Capital Note'

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 often has a higher interest rate because it is unsecured.

An unsecured debt is one that does not 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 comes with holding these fixed income securities. In effect, the interest rate offered on a capital note is heavily dependent on the credit rating of the business because it is all the investor has to rely on. Furthermore, an unsecured note is subordinated debt, which means that it is ranked below secured notes issued by the borrowing firm. In the event that the company becomes insolvent or bankrupt, the secured note holders will be paid first. Whatever is left from the higher prioritized distribution will be paid to capital note holders. Hence, why capital notes are issued with higher interest rates.

In addition to the high coupon rate on capital notes, capital notes are typically not callable – another feature that may attract investors to purchase the debt instrument. A bond or note that is callable does not guarantee that interest payments will continue for the stated life of the bond since the issuer may redeem the notes prior to maturity. Therefore, investors typically prefer a bond that is not callable as they can expect to receive the fixed interest income stipulated in the trust indenture until the bond matures.

Prior to maturity of the notes, investors may be given the option to convert their holdings into common equity at the issuing company, usually at a small discount to the market price. However, this is only an option as the investor may choose to have his principal repaid in full.

Bank Capital Notes

Banks may issue capital notes in order to cover short-term financing issues, such as being able to meet minimum capital requirements. Banking regulation requires banks to have a minimum amount of capital in their reserves in order to keep functioning. To satisfy regulatory demands regarding 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, in fact, the investment may never be repaid. If the bank eventually closes shop, the note holders will be paid after all secured note holders with the bank have been paid given that the capital notes are unsecured and subordinated.

The decision to pay interest on capital notes is solely the bank’s decision. The bank may decide to continue paying interest, reduce the interest income paid, or stop paying interest temporarily or permanently. Since interest on capital notes is non-cumulative, if the bank misses an interest payment, it does not have to pay that interest at a later date. This means the investor may forfeit any skipped payments on the bonds.

Finally, the bank has the discretion of converting 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 both forms of financing reinforce the bank's capital.

  1. Note

    A note is a financial security that generally has a longer term ...
  2. Secured Note

    A secured note is a type of loan that is backed by the borrower's ...
  3. Discount Note

    A discount note is a short-term debt obligation issued at a discount ...
  4. Bond Anticipation Note - BAN

    A Bond Anticipation Note (BAN) is a short-term interest-bearing ...
  5. Senior Convertible Note

    A senior convertible note is a debt security that contains an ...
  6. Tier 1 Capital

    Tier 1 capital is a term used to describe the capital adequacy ...
Related Articles
  1. Investing

    Why Companies Issue Bonds

    When companies need to raise money, issuing bonds is one way to do it. A bond functions as a loan between an investor and a corporation.
  2. Managing Wealth

    Principal-Protected Investments: Risks, Fees And Regulations

    Discover if these investment instruments hit the right note for you.
  3. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  4. Personal Finance

    How Basel 1 Affected Banks

    The 1988 Basel 1 agreement sought to decrease bankruptcies among major international banks.
  5. Investing

    Understanding Bank of America's Capital Structure (BAC)

    For banks, especially large banks such as Bank of America, capital structure has to both meet funding needs and satisfy the regulator's capital requirements.
  6. Investing

    Twitter Stock: Capital Structure Analysis (TWTR)

    Analyze Twitter's capital structure to understand the importance of equity and debt financing. Identify trends in financial leverage and enterprise value.
  7. Investing

    7 Common Bond-Buying Mistakes

    Find out how to avoid the costly mistakes made in bond portfolios everywhere. Learn to minimize the risk of suffering low or negative returns when trading.
  8. Investing

    Gilead Stock: Capital Structure Analysis (GILD)

    Analyze the capital structure of Gilead Sciences to understand the impacts of debt and equity financing. Identify trends and the major drivers of those trends.
  1. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
  2. What Is the Difference between Tier 1 Capital and Tier 2 Capital?

    Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. Read Answer >>
  3. What is the difference between secured and unsecured debts?

    Learn about the differences between secured and unsecured debt — and how banks buffer risks associated with each type of ... Read Answer >>
  4. Under what circumstances might an issuer redeem a callable bond?

    Understand why an interest rate drop usually compels bond issuers to redeem callable bonds and re-issue them at the new, ... Read Answer >>
  5. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center