A capital note is a form of debt which is issued by the corporations as well as banks. These notes are issued for the purposes of fulfilling the need of short-term funding requirements of the company. The Investors in the Capital notes suffer heavily from the default risk as the capital note holder shall be given a very low priority in the waterfall of repayments, i.e., after the repayments have been successfully made towards the secured creditors.
As the capital notes issued in the form of short-term loan for a specified fixed period by a corporation, the persons investing in a capital notes usually get an interest till the notes mature and the redemption value on the maturity. This instrument as it carries more risk as compared to the secured debt has a high coupon rate. Also, the coupon rate that is provided to the investor for parking their money in a capital note is inversely proportional with the level of credit rating being allotted by the credit rating agencies. Higher the credit rating lower would be the coupon on the capital notes and the cost of borrowing and vice- versa.
The capital notes are typically not callable, hence there is no call risk for the Investor if he invests in the capital notes. Call risk is the risk that the company may redeem the notes by repaying the money earlier borrowed from the investors before maturity, in case the market interest rate falls below the rate at which the capital notes were earlier issued. Hence this is also a big attraction point for an investor who expects to get a fixed rate of interest for a specified fixed amount of time.
However, the capital notes may be convertible in nature i.e. at the investor’s option the same can be converted into equity shares of the corporation typically at the market price or the company may provide a marginal discount on the prevailing market price.
The banks generally issue the capital notes to meet their liabilities which are due in the short term. Also, these securities are issued at times to meet the compliance requirements, such as minimum capital requirements. To fulfil these requirements under BASEL accords the banks issue the capital notes under the Tier-I capital or Tier-II capital.
These capital notes issued by the banks don’t have a fixed term or maturity, moreover, it may happen that the bank may never ever redeem the principal amount. However, in case the bank gets liquidated, then in such a case, the same waterfall approach of distribution shall be a follower as was discussed earlier in the article, as these instruments are unsecured and subordinated. Moreover, these interest on these instruments are non-cumulative in nature, and hence in case the interest payment if skipped by the bank, the same will not get accumulated and does not need to pay the same at a later date. A very pertinent difference that exists between capital notes issued by a bank and a company is that the bank holds the right of conversion of those notes into shares, however, the company’s does not enjoy this right.
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