What Is a Note?
A note is a written promise from a borrower to repay a lender. Like bonds, investors get interest payments and their original investment back, called the principal, at a later date. Notes require the issuer to pay back the principal and interest by a certain date. They are used for things like family loans, safe-haven investments, or complex corporate debts.
Treasury notes and municipal notes are common types, offering tax benefits and relatively stable returns, though unsecured notes can carry higher risk. Unlike bills or longer-term bonds, notes occupy the middle ground in maturity and structure, making it important for investors to understand their risks and market role.
Key Takeaways
- Notes are debt securities similar to bonds but usually with shorter maturity dates.
- Treasury notes, or T-notes, are seen as safe-haven investments due to their U.S. government backing.
- Unsecured notes have higher risks and interest rates because they lack collateral.
- Structured notes combine bonds with derivatives for potentially enhanced returns.
- Municipal notes offer tax benefits and are used to fund government projects.
Understanding the Mechanics of Financial Notes
A note is a debt security obligating repayment of a loan, at a predetermined interest rate, within a defined time frame. Notes are like bonds but usually have a shorter maturity date. For example, a note might pay an interest rate of 2% per year and mature in one year or less. A bond might offer a higher rate of interest and mature several years from now. Longer-term debt securities usually offer higher interest rates to compensate investors for their time.
However, notes can have many other applications. A note can refer to a loan arrangement such as a demand note, which is a loan without a fixed repayment schedule. The borrower can demand payment of a demand note at any time. Typically, demand notes are reserved for informal lending between family and friends or relatively small amounts.
Notes can be used as currency. Euro notes are legal tender and are used as paper money in the eurozone. Euro notes are available in denominations like 5, 10, 20, 50, and 100 euros.
Essential Insights for Investing in Financial Notes
Some notes like mortgage-backed notes are used for investments. Mortgage loans can be bundled and sold as a mortgage-backed security. Investors are paid interest payments based on the rates on the loans.
Notes used as investments can have add-on features that enhance the return of a typical bond. Structured notes are essentially a bond, but with an added derivative component, which is a financial contract that derives its value from an underlying asset such as an equity index. By combining the equity index element to the bond, investors can get their fixed interest payments from the bond and a possible enhanced return if the equity portion on the security performs well.
Companies issue secured or unsecured debt with different maturity dates. A capital note is an example of unsecured, short-term debt. It’s important to remember that with any note or bond issued by a corporation, the principal amount invested may or may not be guaranteed. However, any guarantee is only as good as the financial viability of the corporation issuing the note.
Navigating Tax Advantages of Financial Note Investments
Investors purchase some notes for income and tax benefits. Municipal notes, for instance, issued by local governments, provide a fixed interest rate. Municipal notes are a way for governments to raise money to pay for infrastructure and construction projects. Typically, municipal notes mature in one year or less and can be exempt from taxes at the state and/or federal levels.
Protecting Investments With Safe-Haven Treasury Notes
Treasury notes, commonly referred to as T-notes, are financial securities issued by the U.S. government. Treasury notes are popular investments for their fixed income but are also viewed as safe-haven investments in times of economic and financial difficulties. T-notes are guaranteed and backed by the U.S. Treasury, meaning investors are guaranteed their principal investment.
T-notes help raise money for debts, new projects, or infrastructure improvements, boosting the economy. Sold in $100 increments, these notes pay interest every six months and return the full face value at maturity.
Treasury notes have maturity dates of 2, 3, 5, 7, and 10 years. As a result, T-notes generally have longer terms than Treasury bills but shorter terms than Treasury bonds.
Important
Issuers of unsecured notes are not subject to stock market requirements that force them to publicly avail information affecting the price or value of the investment.
Key Types of Financial Notes: Unsecured, Promissory, and Convertible
Governments and companies issue various types of notes, each with unique characteristics, risks, and features.
Unsecured Note
An unsecured note is a corporate debt instrument without any attached collateral, typically lasting three to 10 years. The interest rate, face value, maturity, and other terms vary from one unsecured note to another. For example, let’s say Company A plans to buy Company B for a $20 million price tag. Let’s further assume that Company A already has $2 million in cash; therefore, it issues the $18 million balance in unsecured notes to bond investors.
However, since there is no collateral attached to the notes, if the acquisition fails to work out as planned, Company A may default on its payments. As a result, investors may receive little or no compensation if Company A is ultimately liquidated, meaning its assets are sold for cash to pay back investors.
An unsecured note is merely backed by a promise to pay, making it more speculative and riskier than other types of bond investments. Consequently, unsecured notes offer higher interest rates than secured notes or debentures, which are backed by insurance policies, in case the borrower defaults on the loan.
Promissory Note
A promissory note is written documentation of money loaned or owed from one party to another. The loan’s terms, repayment schedule, interest rate, and payment information are included in the note. The borrower, or issuer, signs the note and gives it to the lender, or payee, as proof of the repayment agreement.
The term “pay to the order of” is often used in promissory notes, designating the party to whom the loan shall be repaid. The lender may choose to have the payments go to them or to a third party to whom money is owed. For example, let’s say Sarah borrows money from Paul in June, then lends money to Scott in July, along with a promissory note. Sarah designates that Scott’s payments go to Paul until Sarah’s loan from Paul is paid in full.
Convertible Note
A convertible note is typically used by angel investors funding a business that does not have a clear company valuation. An early-stage investor may choose to avoid placing a value on the company in order to affect the terms under which later investors buy into the business.
Under the termed conditions of a convertible note, which is structured as a loan, the balance automatically converts to equity when an investor later buys shares in the company. For example, an angel investor may invest $100,000 in a company using a convertible note, and an equity investor may invest $1 million for 10% of the company’s shares.
The angel investor’s note converts to one-tenth of the equity investor’s claim. The angel investor may receive additional shares to compensate for the added risk of being an earlier investor.
The Bottom Line
Investment notes are debt securities that pay interest and return principal, bridging the gap between short-term bills and longer-term bonds. They range from safe-haven Treasury and tax-exempt municipal notes to higher-yield but riskier unsecured notes.
Their flexibility allows use in personal loans, corporate financing, and diverse market strategies. Investors should weigh each note’s risk, return, and tax implications to make informed decisions.
