College degrees, you may have noticed, are not coming cheap these days. Costs at both public and private four-year colleges have more than doubled in the past 10 years, and are still on the way up. The smarter your child, the bigger the bills may be. Next year, parents of Harvard students will pay $14,100 for tuition, room, and board, plus money for books, incidentals, and holiday plane fare home. Other top-tier schools are comparable.
Suggestion No. 1: If your children are young enough, set aside the funds for their education now. Your children's future shouldn't depend on how the economy or your business is shaping up when they are ready for college.
Suggestion No. 2: Fund the prospective tuition bills with zero-coupon bonds. First, project what you think college costs are likely to be when your children are ready for college. Then, based on those projections, buy the appropriate quantity of zeros (see box, right).
Zero-coupon bonds are just what their name implies: bonds with no semiannual coupons to clip. Instead of paying interest every six months, they in effect pay their interest all at once, when the bonds mature.
That means you pay a lot less for a zero than you would for a conventional bond. Recently, for example, you could have bought a $10,000 Allied Chemical Corp. zero, maturing in October 1992, for $3,500. An ordinary eight-year-to-maturity bond with a similar yield to maturity would cost about $6,600.
Zeros also let you lock in today's interest rates. The yield to maturity quoted on ordinary bonds assumes that you reinvest the bonds' coupons at the same rate as when you bought the bonds. But if maturity is some years away, it is hard to know how much you will wind up with. Not so with zeros.
Put together, these features allow for pinpoint planning. Have an eight-year-old due to enter college in 1994? Buy $21,600 worth of zeros today, and you will have the $75,000 that you will probably need to put him or her through a typical four-year private college.
Zeros have been touted as good investments for individual retirement accounts and other retirement plans. There is a reason for that: Buy them outside of a tax-sheltered plan and you are liable for taxes on the imputed income. This leaves you in the unhappy situation of paying taxes on money you haven't seen.
Earmarking the bonds for college, however, means that you can put them in your child's name. Under the Uniform Gifts to Minors Act, you can give your child (or grandchild, for that matter) up to $10,000 a year in cash or securities ($20,000 if the gift is from a couple) without paying federal gift taxes. Income from the investments is then taxed at the child's tax rate, which may well be zero. And although the assets become the child's once he reaches legal age, you can use them in the meantime for any purpose (other than paying for necessities) that redounds to the child's benefit. College counts in that category.
The only real risk with corporate zero-coupon bonds is the chance that the issuing company will go bankrupt before the bond matures. To get around that problem, several major brokerage houses have found a way to turn U.S. government obligations into zero-like assets. They package long-term Treasury bonds, strip off the coupons, and sell investors receipts representing the bonds' future interest and principal payments. The effect is the same as with corporate zeros.
Merrill Lynch Capital Markets, the first firm to offer these investments, called its product TIGRs, for Treasury Investment Growth Receipts. Soon after Merrill's introduction, Salomon Bros. Inc. and Shearson Lehman/American Express created a virtual menagerie with their own tongue-in-cheek-labeled versions: CATS, for Certificates of Accrual on Treasury Securities, from Salomon; and LIONs, for Lehman Investment Opportunity Notes, from Shearson Lehman. Most brokers can purchase any of these feline fineries for you -- or any of the less imaginatively named but similar products packaged by other big houses.
For longer-term investments, packaged Treasuries may be the best bet. "The bond market is so skittish now that the spread between the yield on a good-quality corporate zero-coupon bond and the yield on a Treasury zero-coupon bond is very small," advises Richard Whitman, vice-president at the New York brokerage firm of Oppenheimer & Co. "Why take additional risk when you can have a guarantee from the U.S. government?"
If you do use zero-coupon bonds to save for your child's college education, don't count on their maintaining value in the meantime: As with all bonds, rising interest rates will undermine their market value. But if you have timed their maturities appropriately, they will recover that value in time for you to ship the money off to the ivy-covered walls.