By David Randall

NEW YORK (Reuters) – Little known private colleges that are already struggling to grow their revenues are facing a new threat that could further weaken their finances and make borrowing harder: free tuition at public universities.

The State of New York passed in April a bill that will by 2019 offer free tuition at community colleges and public universities in the state to residents whose families make less than $125,000 per year. At least six other states are considering similar laws, to ease the burden of student debt that has doubled since 2008 to over $1.3 trillion, according to the Federal Reserve Bank of New York.

Fund managers expect that such initiatives, combined with other pressures that have long been building up, will cause bonds issued by smaller private colleges to fare far worse than the broader market if interest rates continue to rise.

So far the bond market has largely ignored such a threat as historically low rates encourage many investors to take on greater risks in search for better yields.

“There are many schools that are going to be losers in this game,” said R.J. Gallo, a portfolio manager at Federated Investors in New York.

Gallo, who owns debt issued by well-known institutions such as Northeastern University in Boston and Northwestern University in suburban Chicago, said that bonds of lower-rated schools yield only about 1.3 percentage points more than AAA-rated ones. That, for him, is not enough to compensate for the additional risk.

Nearly 80 percent of college-age students in New York qualify for the scholarship, according to state estimates. While the state has yet to say how many new students it expects to take advantage of the plan, analysts say that they expect a significant number forgoing private colleges located in the Northeast and opting for public options instead.

RECORD HIGH ‘DISCOUNT RATES’

The prospect of competition from free public programs comes at a time when many private colleges are already forced to offer incoming students discounts because of stagnant personal incomes and years of above-inflation tuition hikes.

The proportion of gross tuition revenue that is covered by grant-based financial aid averaged a record 49.1 percent for full-time freshmen in the current school year, according to a May 15 report by the National Association of College and University Business Officers.

The average U.S. private non-profit four year institution charges $45,370 per year in tuition, room and board, a 12 percent increase over the last five years, according to the College Board. Graphic: http://tmsnrt.rs/2qHVUBj

Moody’s forecasts that financial pressures will triple the number of schools that close their doors nationwide from today’s rate of two to three schools per year. Free public education will add to those pressures, said Christopher Collins, an analyst at Moody’s.

“It’s a highly competitive sector and there’s also now the fact that these really small schools are competing with public colleges and universities with a much lower price,” he said.

Given that there are more than 1,000 private colleges and universities nationwide, closures are rare.

Earlier this year, Connecticut’s Sacred Heart University and St. Vincent’s College announced plans for a potential consolidation. Last November, Dowling College in Long Island, New York, filed for bankruptcy after defaulting on $54 million in debt issued through local government agencies.

New York’s scholarship plan alone is unlikely to cause any private school to go under, said college financial aid expert Mark Kantrowitz, the president of consulting service Cerebly Inc. Instead, regional private schools that tout their small class sizes may lose their appeal if the competition from free programs forces them to lower tuition and they try to offset that by increasing enrollment.

“These colleges justify their costs by saying that you will get a more personal education, but will increasingly start to fail,” he said, adding that he expects to see more private colleges closing their doors over the next decade.

Nicholos Venditti, a bond fund manager at Thornburg Investment Management in Santa Fe, New Mexico, said he has been cutting his funds’ exposure to private college debt in part because other states could soon emulate New York’s model.

“If free tuition becomes a widespread phenomenon, it puts pressure on every higher education model throughout the country,” he said.

(Reporting by David Randall; Editing by Jennifer Ablan and Tomasz Janowski)