Merrill Lynch & Co., the only firm so far to sell a municipal derivative product to retail clients, hopes to do so again in an upcoming San Diego County issue.

This time, Merrill's product is a taxable bond with a payoff linked to the return on a stock market index such as the Standard & Poor's 500, much like the S&P 500-linked certificates of deposit offered by commercial banks.

In March, Merrill sold about $15 million of Tax-Exempt Enhanced Municipal Securities exclusively to retail investors. The stock-linked derivative will be offered to institutional accounts as well as Merrill's retail clients.

San Diego County is planning to sell about $430 million of bonds early next month to meet its unfunded pension liability. The Tax Reform Act of 1986 prohibits municipalities from issuing bonds exempt from federal taxes if the proceeds are used to meet pension obligations. The bonds will be exempt from California state taxes, however.

"We're going to allow for stock index-linked bonds in the documents and then it will depend on the pricing," said Neil Rossi, assistant investment manager for the county. The derivatives portion of the deal could reach $100 million, Rossi said.

The stock market has outperformed the fixed-income market historically, according to Samuel B. Corliss Jr., managing director of municipal derivatives at Merrill. "There is a clear benefit to investors as the returns in the equity market have been higher." he said.

By selling the derivative product and entering a hedging agreement with Merrill, the county hopes that for the derivatives portion of the deal it will lock in a fixed rate 10 to 15 basis points lower than it would pay on ordinary bonds.

The county and Merrill have not decided in what denominations to offer the stock index-linked bonds, Rossi said. "We wouldn't object to small denominations for mom and pop on this product as long as [the buyers] were aware of the risks and understood the product," he said.

Corliss agreed. "These are not targeted per se to small investors, but will probably be available in small denominatins. It may be offered on a limited basis to retail investors," he said.

Other sources familiar with the transaction said that if the derivatives are included in the deal, they would "almost definitely" be available in $1,000 denominations for small investors.

When commercial banks sell stock-linked certificates of deposit, investors' principal is insured, up to $100,000, by the Federal Deposit Insurance Co.

San Diego expects to include bond insurance on its stock-linked securities that would cover the principal and at least a portion of the interest, sources familiar with the transaction said. The securities would be rated triple-A with the insurance.

The county's bond sale will effectively refinance its unfunded pension obligation at today's low rates. About 15 years ago, the county adopted a 30-year plan to pay off an unfunded obligation owed to its retirement program, which is responsible for paying retirement benefits for county employees. Under the plan, the county pays an effective rate of 8% on the unfunded liability to the program.

By issuing taxable bonds at a rate of 6%, the county hopes to save almost $50 million for the remaining 14 years, Rossi said.

Earlier this year, commercial banks began offering certificates of deposit linked to the S&P 500 to ward off the "sticker shock" some investors experienced when their high-yielding CDs matured and the banks offered them new CDs at much lower rates. To keep the investors from rolling over their money to mutual funds, the banks devised certificates of deposit that paid a variable rate based on the return of the stock market index.

Unlike the Merrill product, some of the stock-linked CDs would pay investors no interest if the stock index declined. In contrast, the Merrill product would guarantee a minimum rate, which has not yet been determined, if the index declines. The product will be structured as a zero coupon bond, paying all interest at maturity.

Because the, San Diego deal is a taxable issue, it offers a rare opportunity for Merrill to use the S&P 500 on a municipal deal.

Several underwriters have considered selling a similar derivative on bonds exempt from federal taxes. But the ideas were abandoned after attorneys concluded that the Internal Revenue Service would object.

Merrill first sold derivatives to retail buyers on a $740 million Puerto Rico Telephone Authority issue in March. The firm sold about $15 million of the authority's bonds as Tax-Exempt Enhanced Municipal Securities.

The six-year securities pay a guaranteed fixed rate of 3% plus a variable component that rises as the J.J. Kenny seven-day index falls, and vice versa. The securities were sold in denominations of $5,000, with a minimum purchase of $25,000.

Although Merrill officials said they took elaborate steps to ensure that the derivatives were sold only to investors who understood them, federal regulators were concerned. After the Puerto Rico TEEMs received a lot of press attention, Merrill officials met with officials at the Securities and Exchange Commission to discuss the product, sources familiar with the meeting said.

The firm has not included TEEMs on any other deal.

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