Capital Note

What is a Capital Note?

A capital note is a short-term debt instrument that companies utilize to pay short-term liabilities, typically those maturing within a fiscal year. They are unsecured and classified as "subordinated debt" and are commonly used by banks to address their immediate capital needs. 

As they represent unsecured fixed-income securities, investors face a significant level of risk when purchasing these notes. Capital noteholders have the lowest priority among all the debt holders of the enterprise. 

If a company faces bankruptcy, these noteholders (which also function as debt instruments) will receive payment only after all other debtholders have been compensated for the default.

It facilitates companies in obtaining short-term funding by providing additional incentives to investors willing to accept the heightened risk associated with this particular type of note. 

Beyond banks, companies also can issue capital notes. Other financial products, such as hybrid securities, subordinated notes, preference shares, or convertible preference shares, share similar features and risks.

Understanding Capital Notes

Investors buy capital notes and lend funds to the issuer for a specified duration. In exchange, they receive regular interest payments until the notes reach maturity, at this point, the principal amount is returned to the note holders. They typically offer a higher interest rate, as they lack collateral.

Because they guarantee payments through the complete trust and creditworthiness of the issuer, investors seek a higher interest rate to compensate for the default risk associated with holding these fixed-income securities.

The business's credit rating significantly influences the interest rate for these notes, a key consideration for investors. 

Since they are subordinated debt, they come after secured notes regarding payment priority if the company faces financial trouble. Secured noteholders get paid first; whatever is left goes to capital noteholders. To make up for the higher risk, they offer higher interest rates.

They generally do not have a callable provision and come with the added benefit of offering high coupon rates to noteholders. This signifies that the issuer is prohibited from redeeming or repurchasing the notes throughout their duration.

Yet, there is no assurance that the entity issuing the notes will continue making interest payments until maturity, as it retains the option to redeem the notes.

If a bond is callable, the issuer can pay it off early, which may disrupt expected interest payments. Investors usually prefer non-callable bonds because they guarantee receiving fixed interest income until the bond matures, as per the trust agreement.

Bank Capital Note

A Bank Capital Note, also known as a Bank Capital Instrument or Bank Capital Security, is issued by a bank to raise capital. 

Banks are subject to high regulations and are required to uphold a minimum level of capital reserves to operate effectively as financial institutions.

It serves as a source of bank capital and contributes to meeting regulatory requirements, indirectly supporting financial stability.

Within the Basel Accords framework, banks can include Capital Notes as part of their Tier 1 or Tier 2 regulatory capital. 

Tier 1 notes support the essential operations of the bank, while Tier 2 notes serve as additional capital held in undisclosed reserves. Banks can utilize Tier 1 notes for credit facilities.

Bank Capital Notes Characteristics

The following are the features of bank capital notes:

No fixed maturity date

They don't have a fixed payback date, and there's no guarantee they'll ever be repaid. If the bank shuts down, those holding these notes will only get paid after all secured noteholders are settled, as these are unsecured and come lower in priority.

Autonomy in Interest Payments

The bank has the authority to determine whether or not it will pay interest on the notes. It can choose to maintain, decrease, or halt interest payments temporarily or permanently. 

If the bank fails to make an interest payment, it is not obligated to compensate for it later because interest here is non-cumulative. Consequently, investors may lose out on any missed bond payments.

Convertible Notes

The bank has the authority to change its notes into shares in either the bank itself or its parent company. In the Basel tiers framework, these are considered similar to equity because both types of funding strengthen the bank's capital position.

These notes are actively traded on significant stock exchanges such as the New York Stock Exchange and undergo significant price variations in the market. The exclusive right to repurchase these notes lies with the issuing bank; investors cannot initiate or request such a decision.

Features of Capital Notes

This financial tool may resemble other debt instruments, yet notable distinctions in its functions set it apart. Let's examine the key features that differentiate it from similar instruments:

1. Guaranteed Returns, Unsecured Investments: These fixed-income securities ensure investors receive fixed returns until maturity without collateral.
2. Variable Interest Rates: The interest rates on these securities fluctuate based on a floating system, influenced by factors such as credit ratings and margins set by issuers.
3. Quarterly Interest Payouts: Investors receive regular quarterly interest payments until the issuer repays the debt.
4. Blend of Equity and Debt: These instruments exhibit equity and debt characteristics but with a fixed-term structure to mitigate risks.
5. Extended Maturity: Typically, these notes have a longer lifespan, lasting beyond 10-15 years. For instance, in July 1964, First National Bank of Atlanta's capital notes had a 25-year maturity with a 3.5% coupon rate.

Capital Note Examples 

Let's consider the following examples to understand these notes:

A) Example 1

Company A, having $30 million in total debts (with $12 million being short-term), decided to issue $40 million in capital notes to meet its financial needs. These notes have a 4% coupon rate and a 20-year maturity period.

The company pays investors a quarterly interest of $4 per share for the first ten years. At the end of the twentieth year, XYZ Ltd successfully repays the debt, returning the principal amount of $800 per share to the investors.

B) Example 2

In July 2023, ANZ Group completed the sale of ANZ Capital Notes, generating $970 million. This news was featured in recent reports on investment banks. 

The main goal of this issuance was to replace the earlier note 3 with a new capital note with a 3.6% margin, first introduced in 2015.

Advantages and Disadvantages of Capital Notes

Let’s understand some of the advantages and disadvantages of Capital Notes.

Advantages are:

1. Investors Benefit: They earn attractive interest payments on the acquired notes, maintaining consistent returns through fixed-income securities, contingent on the issuer's performance.
2. Interest Deductibility: Interest payments are typically tax-deductible for the issuing company. This can be advantageous in terms of reducing the overall tax liability.
3. Lower Cost of Capital: They might offer a more cost-effective way of raising capital than issuing common stock. Investors might accept a lower return since they get interest payments. So, companies might find this a good option for fundraising.

Disadvantages include:

1. Interest Rate Risk: They carry a fixed interest rate, exposing the issuer to the chance of increased costs when interest rates rise.
2. No Voting Rights: Unlike common equity, note holders usually do not have voting rights in the company. This lack of control may disadvantage investors who want a say in corporate decisions.
3. Market Sensitivity: The market value of these notes can be influenced by shifts in interest rates and economic circumstances. If market conditions worsen, there is a possibility that the notes' value may decrease.

Tax Implications for Investors in Capital Notes

Here's an exploration of the key tax considerations for investors:

1. Interest Income Taxation: Interest income derived from notes is generally viewed as taxable for investors, and the specific tax rate is contingent upon the investor's tax bracket.
2. Tax Deductibility for Issuers: The company that issues the notes may benefit from tax deductions on interest payments, potentially contributing to managing their tax liability. This advantage may enable issuers to provide investors with more appealing interest rates.
3. Characterization of Interest Payments: Interest income from the notes is typically categorized as ordinary income for tax purposes. The tax treatment remains similar whether interest is paid in cash or additional capital notes.
4. Callable Notes and Tax Implications: Investors should be mindful that when a note is called before reaching maturity, they could face challenges in finding similar investment opportunities and might experience possible tax implications. This may result in investors realizing capital gains or losses.
5. Foreign Issuers and Withholding Taxes: For notes issued by foreign entities, investors may be subject to withholding taxes. Tax treaties between countries can change how much withholding tax is taken.
6. Tax Reporting and Documentation: By utilizing the applicable IRS forms, investors should ensure they accurately report interest income on their tax returns. 
   The key to precise tax reporting lies in maintaining detailed records of interest payments, purchase prices, and maturity information.

Capital Note vs Convertible Note

Let's understand the differences between Capital Notes and Convertible Notes:

Authored and researched by Rani Thakur | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Amortized Loan
• Broker
• Loan Structure
• Maturity
• Positive Covenants