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What are Capital Notes?

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  • Written By: Brenda Scott
  • Edited By: Bronwyn Harris
  • Last Modified Date: 03 November 2016
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In an accounting context, capital is money available to a business or individual to invest in order to produce more income. A note is a debt instrument. Capital notes are unsecured loans based on a company’s credit standing. These are issued as a short-term debt and pay a fixed rate of interest.

Capital notes are considered a higher risk than a secured loan, since they rank lower than all other creditors if the company defaults. As a result of the increased risk, the note pays a higher rate of interest than a secured loan would pay. For an investor who wishes to diversify his portfolio with a product that provides a steady income at a higher return, this may be a good option. For businesses, such notes are a practical way to raise capital.

Banks around the world offer capital notes, also known as debentures, to fund investments, expansion, or to meet mandated capital limits. The laws regarding a bank issue of a capital note may vary from country to country. In the United States, banks can use these as a supplemental source of capital to maintain the mandatory capital-to-asset ratio. Additional requirements include the following; the notes must be for a minimum term of seven years, they cannot have a call feature which allows the investor to cash in prior to the maturity, and they must stipulate that the bank exchange the notes for common stock at a future date for a predetermined price.

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In Australia, capital notes are sold on the Australian Stock Exchange. These are generally classified as moderate risk, and offer semi-annual payments at a fixed rate of return. New Zealand offers capital notes, also referred to as corporate bonds, on the New Zealand Debenture Exchange, and requires that the notes include a conversion option at maturity. If the buyer chooses convert the loan instead of extending it, the issuer can either pay back the principal or replace the note with discounted common shares. In other countries, banks and businesses may offer notes directly to the public.

Capital notes are the lowest priority financial instrument found in a structured investments vehicle (SIV). An SIV is a pool of assets, or investment products, which create a financial instrument and provide additional financing opportunities for the underlying investments. The cash flow from these underlying investments is then diverted to the investment group to pay back the indebtedness. The pools use a variety of products, all of which have higher standing than the capital notes, which means the notes will be the last to be paid if cash flow decreases.

Investors who are attracted to the idea of adding a higher-interest yield, income-producing investment, should do research into the terms of various capital notes before committing any funds. The level of the risk associated with the note is determined by the credit rating of the company and what rank the note has in relation to other corporate debts. The rank will determine the order in which debts are paid if the company goes out of business. Some companies do not offer credit ratings, increasing the risk of the investments, while other companies actually secure insurance for their notes.

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