What Is a Note?
A note is a legal document that serves as an IOUfrom a borrower to a creditor or an investor. Notes have similar features to bonds in which investors receive interest payments for holding the note and are repaid the original amount invested—called the principal—at a future date.
Notes can obligate issuers to repay creditors the principal amount of a loan, in addition to any interest payments, at a predetermined date. Notes have various applications, including informal loan agreements between family members, safe-haven investments, and complicated debt instruments issued by corporations.
Key Takeaways
- A note is a legal document representing a loan made from an issuer to a creditor or an investor.
- Notes entail the payback of the principal amount loaned, as well as any predetermined interest payments.
- The U.S. government issues Treasury notes (T-notes) to raise money to pay for infrastructure.
Understanding Notes
A note is a debt security obligating repayment of a loan, at a predetermined interest rate, within a defined time frame. Notes are similar to bonds but typically have an earlier maturity date than other debt securities, such as bonds. 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. A debt security with a longer maturity date typically comes with a higher interest rate—all else being equal—since investors need to be compensated for tying up their money for a longer period.
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. Payback of demand notes can be called in (or demanded) at any point by the borrower. Typically, demand notes are reserved for informal lending between family and friends or relatively small amounts.
Notes can be used as currency. For example, Euro notes are the legal tender and paper banknotes used in theeurozone. Euro notes come in various denominations, including five, 10, 20, 50, and 100 euros.
Notes as Investment Vehicles
Some notes are used for investment purposes, such as a mortgage-backed note, which is an asset-backed security. For example, mortgage loans can be bundled into a fund and sold as an investment—called 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 can issue both secured and unsecured debt securities that carry varied maturity dates. A capital note is an example of an unsecured and 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.
Notes with Tax Benefits
Some notes are purchased by investors for their income and tax benefits. Municipal notes, for example, are issued by state and local governments and can be purchased by investors who want 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.
Notes as Safe-Havens
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 can be used to generate funds to pay down debts, undertake new projects, improve infrastructure, and benefit the overall economy. The notes, which are sold in $100 increments, pay interest in six-month intervals and pay investors the note's full face value upon maturity. Treasury notes are offered with maturity dates of two, three, five, seven, and 10 years. As a result, T-notes generally have longer terms than Treasury bills but shorter terms than Treasury bonds.
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.
Other Types of Notes
There are many types of notes that are issued by governments and companies, many of which have their own 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 Scottin 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.
