You have a couple of basic options for your investment dollars, equity securities or debt instruments, although those two options can wear many faces. Equities are things you own, like real estate or stocks. Investing in debt means putting your money out at interest -- for example, by purchasing a bank certificate of deposit or a U.S. Treasury note. Bonds and promissory notes are similar types of debt investments, but they have some significant differences.
In its broadest form a promissory note is nothing more than a written promise to repay a debt. The agreement could be between two individuals. For example, if you sell your car to an individual and agree to finance the car for that person, you might have him sign a promissory note detailing the terms of the loan. You might have signed a master promissory note with the U.S. Department of Education if you took out a national direct student loan. In the world of corporate finance, companies sometimes use promissory notes as a means of alternate financing rather than borrowing from a bank or issuing bonds.
A bond is a more formal type of debt instrument. When you buy a bond you're loaning money to the issuer, which could be a corporation or government, in exchange for regular interest payments plus the return of your principal. The terms, such as the bond's maturity date, interest rate, interest payment dates and and special features -- including call or early redemption options -- are detailed in the bond's indenture.
Promissory Note Pros and Cons
Promissory notes typically offer a higher interest rate than comparable bonds from the same or similar issuer. This increased income makes them attractive to investors looking to maximize their return. But a higher return almost always involves a higher level of risk, and promissory notes are no exception. Promissory notes are typically the domain of institutional investors or well-heeled, sophisticated individual investors with the experience and access to information to determine whether the offer is suitable for their portfolios. The U.S. Securities and Exchange Commission suggests asking tough questions before investing in promissory notes, noting that scam artists have bilked unwary investors out of tens of millions of dollars using fraudulent promissory note schemes.
Bond Pros and Cons
Bonds issued by agencies of the federal government, such as U.S. Treasury bonds, are among the safest investments in the world. Because they're so safe they tend to pay minimal interest rates compared to other types of bonds, but that interest is exempt from state and local income taxes. Investment-grade corporate bonds pay higher interest than other types of bonds, but also involve a higher level of risk. The interest on most municipal bonds is exempt from federal income taxes and might be exempt from state and local taxes. Although the risks for municipal bonds and comparably rated corporate bonds is similar, the interest rate offered by municipal bonds is typically lower due to the tax advantages.
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