What is a capital note?
A capital note is a special kind of bond. Banks and bank holding companies issue them. They have some unique features compared to regular corporate bonds.
Capital notes can count toward a bank’s Tier 2 capital. This helps the bank meet rules about how much money it needs to have. The rules make sure banks stay safe if they have money problems.
Features of capital notes
Capital notes have to follow certain rules to be part of Tier 2 capital:
- They can’t be “callable.” This means the bank can’t pay them back early.
- When first issued, they have to last at least 7 years before being paid back. This is called the note’s “maturity.”
- Some capital notes have to change into the bank’s common stock shares when they mature. These are called “mandatory convertible” notes.
Why banks use capital notes
Banks like capital notes for a few key reasons.
Cheaper than stock
Issuing capital notes costs the bank less than issuing new stock shares. The bank has to pay interest on the notes. But this is still cheaper than giving investors a share of the bank’s profits forever through stock.
Helps meet capital rules
Banks have to keep a certain amount of money and assets compared to what they lend out. This protects the bank if some loans aren’t paid back.
There are different categories or “tiers” of capital. Each tier has its own rules. Tier 1 is the strongest kind of capital, like common stock. Tier 2 is the next strongest. It includes some bonds, like capital notes.
Issuing capital notes is one way for a bank to increase its Tier 2 capital. This helps it meet the rules without having to issue as much expensive common stock.
Delays stock dilution
Some capital notes are “mandatory convertible” into common stock. But this conversion happens years in the future, when the note matures.
This delays any dilution to current stockholders. Dilution is when a company issues new shares, and each share is then worth a smaller piece of the company.
With mandatory convertible notes, the bank gets capital now, but doesn’t have to issue new shares until later. Current investors don’t see their ownership get diluted right away.
Risks of capital notes
Capital notes do have some risks for investors to consider.
Lower priority in bankruptcy
In a bankruptcy, capital notes are lower priority than other bonds. Investors might not get any money back.
This is because capital notes are “subordinated” debt. The investors agree to get in line behind the bank’s other bond holders if the bank fails.
This higher risk is one reason why capital notes pay higher interest rates than regular corporate bonds. Investors demand more return for the extra risk.
Uncertain value if converted
Mandatory convertible notes will change into a fixed dollar amount of the bank’s stock in the future. But the number of shares isn’t set in advance. It depends on the stock price when the bond matures and converts.
If the bank’s stock price is low at conversion time, the capital note investor will get more shares, but they may be worth less in total. If the stock price is high, the opposite happens – fewer shares worth more.
This makes valuing convertible capital notes complex. Investors have to estimate the future stock price to decide what the note might be worth.
