Many parents of college-bound children have a combination of income and deductions that put them into at least a 20% tax bracket - and that can make the after-tax advantage of municipal bonds worthwhile, says Jennifer Elmore, a certified investment management consultant and first vice president at Dain Rauscher Inc. in Denver. Still, she thinks it takes a mighty conservative family to sink all of the funds it has available for its kids' college expenses into municipals.
As Elmore sees it, the municipal bond portion is a kind of a safety-net investment whose income stream the family can count on. "You might invest 25% of the portfolio in municipals, but that's about it," she said. But this doesn't necessarily mean that investors should only consider insured or triple-A bonds. And as long as one is willing to monitor bonds for rating changes on a quarterly basis, single-A or double-A rated bonds are insurance enough, she said. Most major brokerage firms provide ratings information every quarter.
Elmore also advises investors to diversify, but says they needn't go overboard. Citing the example of parents who decide to buy $40,000 worth of bonds to fund $10,000 of college expenses for each of four years of college, they might ladder a portfolio with no more than one different issuer for each of those years. Buying two $5,000 bonds from different issuers for each year would probably be overkill, she said.
Elmore says investors should not rule out using out-of-state bonds, which can bring in richer yields. This is particularly for residents of states like Florida or Texas that don't have income taxes. However, she said that buying out-of-state zero-coupon bonds can bring on an accounting nightmare. In her home state of Colorado, for example, the accreting income on out-of-state zeros is payable annually to the state.
While it might be a good idea to transfer assets to college-bound children once they turn 14, in order to benefit from the tax advantages of a trust for minors, Elmore cautions that parents hoping for scholarships should take note: even academic scholarship committees will look at the assets of a child when deciding who to grant.
In addition, because many scholarships require that students spend half of their assets on tuition, parents should avoid such transfers. In any event, the maturity of the bonds chosen for children should take these issues into account.
Roy Youngman of First Miami Securities
The smartest people start planning from the time they know they're going to start having a family," says Roy Youngman, a senior vice president at First Miami Securities in Boca Raton, Fla.
"My best guess is that you are looking at $75,000 to $100,000 a year for (private) school, 18 years into the future," he said. "I would suggest that for the money you want to be guaranteed to be there, that's where the bond money is - for your risk money it should be in other areas."
Like other managers, Youngman says zeros are a particularly good investment because they take care of the reinvestment problem. And zeros pose a great example of where attention to detail is crucial, he insists. First of all, he urges investors to stick to highly rated zeros, since holders have to wait until maturity to realize any income at all - making credit quality doubly important.
"God forbid something goes under, then you're getting nothing," Youngman says. Secondly, it's essential to avoid zeros that might be called. "You absolutely want to stay away from (zero-coupon) housing issues," he said. "There are a lot of housing issue that came out at high interest rates originally, but they may be called at accreted calls. So when you see a call feature on a zero- coupon bond, it may be 2010 at 100, but that 100 is not par, that's 100% of the accreted value based on what yield those zero-coupon bonds came out at."
"If they came out at a 10% yield for instance, and you're buying them 20 years later at an 8% yield to maturity, you may be buying them at a negative yield to their call," he said.
"I've seen people get hurt with zero-coupon bonds, not because their broker was trying to screw them intentionally, but just because he didn't know what he was dealing in," he added.
In addition, a bond professional might be able to find cost savings through credit specialization. "I can buy triple-B rated zeros, but if you're an individual who doesn't know or trust your broker well, then you want to stay with triple-A zeros," he said.
Most importantly, however, Youngman cautions individuals setting up a portfolio to use professionals specializing in bonds to structure the portfolio and buy your bonds.
"Each individual bond has its own idiosyncrasies and its own nuances to a bond guy. To a wire-house guy, it's got a coupon, a yield, a maturity, a rating, and that's what it is," he said.
"Anytime you run into problems with municipal bonds, it generally is because you're dealing with somebody who doesn't know bonds."
Erwin Shapiro of Sutro & Co.
Arwin Shapiro, senior vice president of investments at Sutro & Co. in Beverly Hills, Calif., was the only financial adviser interviewed who goes so far as to recommend, for investors in a high enough tax bracket, a portfolio comprised 100% of municipal bonds to finance a child's college education.
"See what's going on in the equity markets right now," he said. "You can't make an 18-to-20-year projection on interest rates or equity prices, so it's simple, and simplicity usually wins."
Even municipal bond funds, he says, shouldn't be relied upon because of their fluctuating net asset values. For investors in a high tax bracket, Shapiro says, "the only practical investment is a very high-quality tax-free bond - there's no other product that can assure the safety and comfort and growth of that."
He recommends using insured bonds with at least an A-plus underlying rating.
Shapiro says that prerefunded bonds are an often overlooked - or avoided - because of their complicated structure, but they commonly reward buyers with a higher yield.
But just make sure there's no sinking fund associated with it, he says. Sinking funds require issuers to redeem an established amount of bonds in specific years prior to the bonds' stated maturity. If a redemption occurs, it would stray from the investment goals of the portfolio, which should have laddered maturities throughout the college years, he says.
In that vein, convertible zero-coupon bonds should also be avoided, Shapiro says. Those bonds convert to interest-bearing securities at a set time.
Buying a zero-coupon, laddered portfolio sounds basic, but buying the right bonds is complicated enough that a client must go to a specialist, he said.
"If you needed a root canal, you go to an endodontist, if you need a heart- work, you go to a cardiologist. Why would anyone buy a bond from a stockbroker, or a stock from a bond salesman?" Shapiro asks.
Once the portfolio has been assembled, the process should be analogous to a time capsule, he says: put your funds in now, and take them out 18 years later. As long as the firm stays in business, and statements keep arriving, there is nothing to worry about, according to Shapiro, and that's how it should be.
Swapping the portfolio's bonds can be a means of locking in losses in order to offset capital gains elsewhere for tax purposes, but should be done with great care and attention to the costs of the trade.
The fewer moves you make, the better off you are, Shapiro says: "every time you make a move, somebody makes money off of you" in the form of commissions.
