What are capital notes?
Capital notes are complex financial instruments that combine features of both bonds and shares. This is part of a broader category known as hybrid securities which also include convertible bonds, preference shares and capital notes.
Capital notes generally aim to pay a combination of fixed and floating rate discretionary distributions – a set margin (fixed component) and a variable margin above a defined benchmark such as the 90 day Bank Bill Swap Rate (floating component). Whilst the aim is to provide income akin to a bond, their trading price can fluctuate like shares.
What are the benefits of capital notes?
- Capital notes are generally perceived as less risky than underlying ordinary shares and aim to provide regular and defined income streams in the form of discretionary
- Capital notes provide an opportunity for investors to diversify their
- Capital note distributions are required to be paid in full before any ordinary share dividend can be
- Structure of the margin above a benchmark rate (such as Bank Bill Swap Rate) provides some protection to rising
- Distributions are often scheduled to be paid quarterly and issuers have the potential to pay franking credits. The extent to which distributions will be franked will depend on a number of factors, including capital management activities of the issuer and the level of profits generated by the issuer that will be subject to tax in
What are the risks of capital notes?
Capital notes can differ in structure and have differing levels of risk. As such it is important to read the offer document in full to understand the features and risks of each capital note. Some of the common risks or considerations with this asset class include:
- Liquidity risk – capital notes generally have lower levels of liquidity in the secondary market than ordinary shares which may mean you have to accept a lower price in the event a quick liquidation is
- Seniority ranking – capital notes have a relatively low ranking in the capital structure, senior only to ordinary shares. This means outstanding capital notes holders will be paid ahead of only holders of ordinary shares in the event of
- Perpetual – capital notes generally have no fixed maturity date and will convert to ordinary shares if still on issue (not called at an optional call date) on a mandatory conversion date as long as the mandatory conversion conditions are satisfied. It is possible the notes may remain on issue
- Distributions are non-cumulative – Missed distribution payments do not accumulate, noting that failure to pay a distribution will not constitute an event of
- Write off – capital notes often include trigger events which may cause the notes to be mandatorily converted to ordinary shares and in some circumstances may be written off and deemed
Do I pay brokerage when bidding into a capital notes deal?
No, when bidding into an IPO there is no brokerage paid on your allocation. However, should you choose not to bid and instead purchase the note on the secondary market, brokerage would be payable.
What can cause a capital note to deviate from face value?
As with all asset classes, price fluctuations are to be expected and there are a number of factors that can drive the prices of capital notes including but not limited to:
- The performance of the underlying company
- Changes in credit rating
- Supply and demand for listed capital notes
- Market expectations of required rate of return relative to the fixed margin including those on comparable issuance
- Remaining tenor to first call date
- Liquidity.
Generally, capital notes rise and fall in price inversely to movements in the trading margin (the markets implied fixed component of the margin). As trading margins rise, the capital notes fall in price and vice versa.
Who can bid for new capital note issuance?
Following the introduction of DDO legislation, product issuers are required to develop a target market determination (‘TMD’) which details the class of consumers to whom products are targeted. Since the introduction of DDO, all capital notes distributed by the CBA have contained a target market of Wholesale Investors or retail customers receiving personal advice.
