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.

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