The biggest problem that investors may face when considering California's latest tax-free, zero-coupon bond is whether they will be able to buy enough of them.
Last week, state Treasurer Thomas Hayes announced the "College Savers Program," the keystone of which is a $10-million to $20-million bond issue to refinance the life sciences building at the University of California at Davis.
The bonds, which will be sold Oct. 24, are expected to bear interest rates ranging from 7.25% to 7.50%, depending on their maturity. (They'll be issued with maturities ranging from 10 to 15 years.) Since the bonds are exempt from both federal and state income taxes, the effective yield for high-income taxpayers is near 11%.
Better still, the treasurer's office plans to issue the bonds in unusually small denominations. Face values would go as low as $1,000, compared to a minimum of $5,000 for similar bonds. And since zero-coupon bonds sell at a steep discount to face value because interest is paid only at maturity, investors could buy one of the bonds for as little as $331, the treasurer estimates.
"We call them Grandpa and Grandma bonds because they make such good gifts," said Zane B. Mann, publisher of California Municipal Bond Advisor, a Palm Springs-based newsletter. "It's a good way to accrue a substantial amount of money tax-free with very little cost up front."
There is certainly a need for a low-cost vehicle to finance future college expenses, which have been appreciating substantially faster than the rate of inflation for several years. College expenses increased an average of 9.8% a year during the 1980s, compared to an average inflation rate of 5.3% in the same period, according to the College Board and the investment research firm Ibbotson Associates.
When all expenses--tuition, fees, room and board--are factored in, it costs an average of $14,300 annually to send a child to college. By the year 2010, the College Board estimates, it will cost more than $92,000 a year--an amount that's clearly out of reach for most Americans.
But the College Savers bonds are not just for students. Hayes maintains that there is no restriction on how investors use the money once the bond has matured, so investors can use College Savers bonds to save for retirement or any other future expense.
Moreover, the bonds are backed by the State of California, which makes them extremely good credits. (Similar bonds issued by the state are rated AA by Standard & Poor's, one of the highest ratings available.)
If the state defaulted, the university system would also be on the hook to pay principal and interest to investors, said Manuel M. Mateo, chief of the trust services division at the state treasurer's office.
"It's an extremely safe credit," Mateo added.
Still, over the past several years, both the stock market and the California real estate market have returned substantially more than 11% a year after taxes. In 1989, broad measures of stock market performance indicated that investors would have earned about 32%. Those dabbling in real estate in the late 1980s often raked in 30% annual returns as well.
"On a historical basis, the stock market has outperformed the bond market," allowed Marilyn Cohen, president of Capital Insight, a Beverly Hills-based brokerage. "But I think the lofty rates of return we saw in the 1980s will not be repeated in the 1990s."
If current stock market performance is any indication of the rest of the decade, Cohen is a master at understatement. The Dow Jones industrial average, a key indicator of stock market performance, has slid nearly 5% since the beginning of the year.
The real estate market is in a similar predicament. The California Assn. of Realtors estimates that real estate prices will rise less than 2% in 1990.
Of course, real estate and corporate stocks are not the only options. Investors can also put their money in commodities such as oil and gold; collectibles, such as coins and stamps, and other types of securities, such as junk bonds. However, all of these markets have proven to have pitfalls, such as extreme volatility--gold prices dropped $27 in just one recent trading day--or extreme risks.
The price of zero-coupon bonds can also be volatile. But if investors buy them with the intention of holding them to maturity, the state of California is willing to guarantee investors a market rate of return, tax-free.
The one hitch is that the bonds may be hard to find. There is a very small profit margin on selling this type of bond, and brokers might even lose money if they sell them in small denominations, Mann said. That could limit the number of firms willing to sell College Savers.
Moreover, the treasurer expects to sell a maximum of $20 million worth of the bonds on Oct. 24 and a total of $80 million in the whole program, which will encompass several future bond offerings, Mateo said. That's a minuscule amount compared to annual college expenditures in California, and Cohen believes that it will also prove to cover only a fraction of the demand for the bonds.
THE BOTTOM LINE ON BONDS
The College Savers Program is designed to help parents provide a college education for their children. Some background:
* By the year 2010, the College Board estimates, college education will cost more than $92,000 a year.
* California's new tax-free zero-coupon bonds, which will be sold Oct. 24, are expected to bear interest rates ranging from 7.25% to 7.50%, depending on their maturity.
* The price of zero-coupon bonds can be volatile. But if held to maturity, California guarantees investors a market rate of return, tax-free.
CALIFORNIA COLLEGE SAVERS BONDS
Estimated yield and initial investment to bond purchasers
Initial Years to maturity Yield investment Maturity value 10 years 7.25% $490 $1,000 11 years 7.30% $451 $1,000 12 years 7.35% $420 $1,000 13 years 7.40% $389 $1,000 14 years 7.45% $360 $1,000 15 years 7.50% $331 $1,000