SIMPLE can be considered boring but sometimes simple is exactly what we need. I recently met with a prospective investor (virtually, of course) who had gotten badly burned in the stock market. After licking his wounds he decided he was ready to invest again, but after his bad experience he wanted a simple, short-term investment that would allow him to sleep better at night. A promissory note seemed like the best fit.

WHAT IS A PROMISSORY NOTE?

When I explained what a promissory note was, he remarked that it sounded a lot like a bond, and he was not wrong. A promissory note, also called a P note, pro-note or even just a note, is essentially a contract between two organisations, or between an issuer and a lender or investor, governing a one-time loan. The contract will include the agreed-upon terms such as the interest rate, maturity date and a written promise on the part of the issuer to pay back another party. On the surface of it this sounds a lot like a bond, doesn’t it?

PROMISSORY NOTES VERSUS BONDS

In many ways bonds and promissory notes are very similar. In fact, bonds are often classified as types of promissory notes. Both bonds and promissory notes are financial debt instruments, are issued by organisations to raise money, and are best-suited for investors who are interested in a more dependable source of future income than stocks. However, there are a few key differences between the two.

Bonds have more conditions and a longer maturity, usually five years or more, whereas promissory notes are short-term investment securities.

Another key difference between promissory notes and bonds is who issues them. Typically, only large companies, local governments or sovereign countries can go through the lengthy process and have the resources required to issue bonds. Almost anyone can issue a promissory note and so it is important to know if the note is registered with the relevant financial regulators.

Registration is important because the process involves what is known as “due diligence”. This means that financial professionals, usually including lawyers and accountants, have reviewed the terms of the note and company behind the note. While due diligence does not guarantee that you will be repaid, it means that you are much more likely to be given accurate information that will help you make an informed decision. Bonds are always registered but notes can be sold without being registered. Unregistered notes are extremely risky, and the investor has no recourse if the company defaults. A red flag that might indicate that a note is not registered is if the note pays a much higher rate than what the market is offering on other short-term, low-risk instruments.

‘Liquidity’ refers to the efficiency or ease with which an asset or security can be converted into ready cash. Herein lies another difference between bonds and promissory notes. Bonds as an asset class are more liquid because they can be sold/traded on a secondary market, whereas pro-notes cannot. However, some notes are structured with a “put option” for the purchaser (that is, the note holder). This feature allows the note holder to “sell” the note back to the issuer under specific terms. The terms and conditions will describe the timing of payments and when and if you can sell the note.

The fact that pro-notes are not traded means that their market value does not fluctuate, which is a good thing if you are an investor who cannot manage volatility, but it also means there is no opportunity for capital gains. With a promissory note you invest your principal for a short period of time, earn the stipulated interest, and collect your principal at maturity. It is as simple as that!

Toni-Ann Neita-Elliott, CFP is the vice-president, sales & marketing at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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