Both bonds and promissory notes are types of debt used by issuers to raise non-equity financing. That means the holder of the bond or note is entitled to repayment of his investment, plus interest paid on a set of specific terms and at agreed-upon intervals, but has no ownership claim on the borrower that issued the bond or note. Bonds tend to be more complicated than notes, and are only issued by large borrowers.
Bonds Are Big
In some ways, a bond is really just a type of promissory note with more conditions and a longer maturity. Bonds typically have maturities of five years or more. Bonds will also be issued together, in one large offering -- usually at least a few tens of millions of dollars -- in which all the bonds will have the same conditions, known as “terms”. For example, company X might launch a bond issuance of $100 million with a 10-year maturity and a 4-percent "coupon." The coupon is the nominal interest rate of the bond. All the bonds in that issuance will be exactly the same.
Like stocks, bonds are commonly traded securities, and it’s usually easy for investors to learn about the credit worthiness of an issuer. Credit agencies such as Standard & Poor's, Moody’s, and Fitch assign letter grades to bonds based on the likelihood that the borrower will pay back the loan. Bonds are technically complicated securities that are difficult for small companies with few resources to issue. Typically, only large companies, local governments or sovereign countries are able to go through the lengthy process required for an issuance, so bonds aren’t a very good way for smaller lenders to raise debt financing.
On a Modest Note
Where bonds typically have maturity periods of five years or more, promissory notes are short-term investment securities. Unlike the case with bonds, almost anyone can issue a promissory note. As a debt instrument, then, it’s a way for borrowers to obtain credit without having to go through the process of applying for a bank loan or having an investment bank underwrite a bond offering. Since the note is a security, the issuer still needs to register it with security regulators to make it legal. If you buy a promissory note, you’re implicitly assuming the job of determining the credit-worthiness of the borrower, something that a bank usually does.
Promissory notes represent a kind of debt usually sold to other corporations or to sophisticated investors. Unlike bonds, it’s unusual for promissory notes to be marketed to specific investors. In fact, promissory notes sold to individual investors can frequently be scams, so be wary if approached by a broker or insurance agent about investing in these securities. You can check with the Securities and Exchange Commission or your state’s security regulator to verify that the note is legitimate.
- Jupiterimages/Photos.com/Getty Images