Attractive features of zero coupon bonds mask some drawbacks

They look like the perfect investment. There's almost no risk. You know exactly how much money you'll make. And you know how long it will take to make it. They go by a lot of names, but they're best known as zero coupon bonds. For the last two or three years, brokers have been touting them for all kinds of uses, but especially for parents salting money away for the kids' college bills, and for people planning to retire in ten years or so.

State and local governments have been selling zeros for many years, but the investment got a lot more attention when major brokerages like Merrill Lynch and Shearson Lehman Brothers began selling United States government-backed zeros with names like TIGRS and CATS in 1984 and '85.

Before signing up for one of these ``guaranteed'' investments, look carefully at both the contract and some facts that aren't in that document.

First, says Barbara Drebing, a financial planner in Philadelphia, ``these tend to be very high commission products. There have even been lawsuits where brokers were charged with basing commissions on the face value of the bond, instead of the discounted rate.''

With a zero coupon bond, you might pay $4,500 today and get back $30,000 in 17 years. In that time, you don't receive any money or coupon payments - thus zero coupon - you just get that big lump of money in the future. In this case, the broker's commission should be based on the initial $4,500 you handed over, not on $30,000 or anything in between.

It's also good to remember that if the broker in this example is giving you a profit of $25,500 in 17 years, the brokerage is making even more than that. How much more depends on the firm, but one or two percentage points is not uncommon. If you're sure you can't do better than that over 17 years, or whatever period you choose, zeros may be fine, but many people have done better.

Another important consideration is the fact that you're locking up your money in today's interest rate environment and keeping it there until the bond matures - no matter what interest rates do in the meantime. If rates don't move or go down, you'll come out ahead. But if rates rise, you won't be able to take advantage of them with this money.

It is possible to sell the bonds early on the secondary market however. ``These are liquid, which means you can sell them,'' says Gerald Guild, director of fixed income investments at Advest Inc., a brokerage.

Mr. Guild believes investors can get too caught up in the interest rate game, trying to catch rising rates and avoid falling rates.

``Too many people are speculating on interest rates,'' he says. ``They're second guessing themselves.'' He advocates committing a portion of the overall investment portfolio to the assured rates and - in some cases - government guarantees of zeros. Besides, he says, while zeros' current rates aren't at all-time highs, they're not that bad, just over 9 percent.

Whatever interest rate you receive, don't forget that part of it goes to the tax collector, unless you're using the zero for a tax-sheltered retirement account or in a college-education fund. You have to be careful with the college fund, though, since under the new tax law, any interest over $1,000 earned in the account of a child under age 14 is taxed at the parents' rate.

Even if the parents do have to pay the taxes, the end result may be worth it. Let's say you put $7,000 into a zero today for a child entering college in 18 years. At that time, he or she would receive $60,000, or $15,000 a year for four years, with the taxes already paid.

If the zero is not in a tax-sheltered account, the interest is taxable each year it's credited to your account, even though you don't receive any of it until maturity.

Ms. Drebing, who admits she's ``not too high on zeros,'' suggests some alternatives for people saving for retirement or college. ``I'd go with a combination of bank CDs and low-volatility mutual funds.'' The certificates of deposit, she says, should be short-term, no more than three or four years. And in the current environment of rising rates, they should probably be even shorter, like a year or less.

At the same time, she would look for a mutual fund that outperforms the averages in a bull market (it doesn't need to outperform them by much) and - more important - hangs onto those gains when the market goes down.

The last point to remember about zeros is early calls. This usually happens with those issued by local and state governments or agencies. They don't like to pay high rates any more than you do, so when rates fall, they will ``call in'' the bonds by paying them off a few years early.

Any bonds that aren't returned by investors simply stop earning interest. So it's important to pay close attention to call notices, or have a broker who will do this for you. If your bond has an early call provision, it will say so on the bond or in the prospectus, and you should check on it at least once a year to make sure that great interest rate on your zero coupon bond doesn't suddenly drop to zero.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway St., Boston, MA 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.

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