Invest $450 now, get $1,000 back in the year 2000, and pay no income tax on your earnings!
If that's the sort of proposition that appeals to you, you might want to check out an increasingly popular investment known as zero-coupon municipal bonds.Despite their somewhat ponderous name, municipal zeros aren't all that complicated.
They are close cousins, in fact, of U.S. savings bonds, and can be used for many of the same purposes and goals as savings bonds.
One big difference: While you may well eventually have to pay taxes on the money you earn from savings bonds, there is no federal tax on income from the typical municipal zero issued by a state or local government.
Savings bonds, of course, are sold through a long-established national program, and are easily accessible at banks and other financial institutions, or even from your employer through payroll deductions.
Municipal zeros, which trace their origins back just a few years, aren't yet so widely available.
But inquiries at brokerage firms in your area may lead you to one of several firms that creates zeros from ordinary municipal bonds through a process, called stripping, that separates them from their current interest payments.
The Cleveland-based brokerage firm of Prescott, Ball & Turben Inc. calls the municipal zeros it sells Stripped Tax-Exempt Participations, or STEPs.
A few states, in addition, have begun offering bonds specifically designed as zeros.
In December, Connecticut offered the first in what is planned as twice-a-year sales of College Savings Bonds with maturities of five to 20 years. For Connecticut residents, they are exempt from both federal and state tax.
Since zeros pay no current interest, they are obviously unsuitable for people who want or need income from their investments to help them meet living expenses. Rather, they are designed to appeal to people saving for some future goal.
Buyers of zeros pay a fraction of the bonds' face value that is calculated to produce a certain annual compound growth rate until the bonds are redeemed on maturity at face value.
They eliminate the uncertainty that comes with conventional bonds about what reinvestment options will be available for interest as it is paid out over time.
"We can think of no investment vehicle whose results are more clearly defined," says Prescott, Ball & Turben in its monthly publication Investor News. "For that reason, zeros are of great value in financial planning."
Drawbacks and possible pitfalls? Yes, there are several.
In their eagerness to get a tax break, many buyers of municipals often don't bother to calculate whether they might actually do better, even after taxes, in some other type of investment.
With a municipal zero, you can know precisely what after-tax dollar amount you can expect to receive in 1995, or 2000, or 2005.
But because of inflation, there is no way of telling in advance how much purchasing power those dollars will have - for example, whether they will cover a college tuition payment or not.
Furthermore, if inflation increases, zeros offer you no protection. In fact, assuming that the general level of market interest rates rises along with inflation, the value of a zero will fall should you want to sell it before maturity.
The automatic compounding feature of zeros that appeals to so many investors actually exaggerates this effect. So their market values tend to fluctuate even more than those of conventional bonds with the ups and downs of interest rates.