Very few things are guaranteed in life, right? Death, taxes (but there are ways around them if you're rich enough to hire the right people), Washington beating Alabama (hey, it could happen) on New Years' Eve, etc. But there are also a few things with a near-guaranteed outcome. One of these is what happens to those that believe muni bonds are safe, and really have no principal risk.
While it's true that if you buy a muni bond, hoping to earn tax-free income and have it grow or at least preserve principal, and hold it to maturity you will get your original capital back, this is less so when you use muni bond funds as your vehicle for tax-free income investment. Since there is no fixed maturity, the principal (called NAV, or net asset value) fluctuates in the opposite direction of interest rates the entire time you hold the fund. Therefore, if you ever need the money during a rising interest rate environment, you'll have to accept less principal than you originally put in.
Most of us buy muni bond funds believing we don't need that capital, and will be able to withstand any decline in price. However, that is rarely possible to know for sure, for most of us with limited funds, as things tend to happen in life that are not predictable.
Looking at the picture below, a monthly bar chart of iShares National Muni Bond (MUB) (a national muni bond fund), there are some objective reasons that this may be the time to cash in on your tax-free investments before the decline shown by the blue arrows runs its course. This should be of concern if you might need that principal in the coming three to four years, with, as you can see, the price of MUB anticipated to fall toward the $80s into that timeframe.
From the recent highs, that would entail a 26% drop in principal, offset by the small amount of interest the fund would send you. Given this scenario, a total return of -20% would not be unreasonable. Now, the question becomes, can you tolerate that potential loss if you need your money while the NAV is in decline?
Let's review the objective indicators that are skewing the investment equation away from reward and toward risk, as our decision support engine (DSE) analyzes the lay of the land. First, note the falling stochastics (lower pane in chart), which became seriously overbought into this summer's peak, triggering a long-term sell signal upon the break below the stochastic 90% threshold. That indicator hasn't changed its stance, and prices are still vulnerable to further decline.
With the FOMC expected to raise rates at the Dec. 13-14 meeting, and several additional rate hikes coming in 2017, the path for rates appears to be higher, which should put continuing pressure on NAVs of all bond funds.
In addition, as can be seen from the lower left of the chart to the upper right, the rising trend off the 2008 low appears to have completed an impulsive five-wave structure, which is the footprint of a mature trend under the rules of Elliott Wave Theory. Per Elliott's pattern recognition guidelines, the next expectation following a mature trend structure is a three-wave structure in the opposite direction, which serves to relieve the overbought condition into the rally's maturity.
Working with Elliott's analysis companion, Fibonacci retracement ratios, we can see that the typical correction targets the zone between the 38% and 62% retracement levels (upper green box), with a chance of a test of the 78% level in the lower green box. This is where the -26% number comes from, as mentioned above.
With this in mind, we ask the decision support question, "If I had no money in MUB, are buying or selling actions objectively indicated right now?" The answer is a resounding selling actions only.
So, if investors are even potentially going to need capital in these kinds of assets or mutual funds, exiting while prices are still in the pink sell box is optimal. Aggressive speculators would use a break below that box to sell short, and use $112 as your protective buy stop. This would give at least a 6:1 reward to risk stance to short-sellers, assuming only a downside move to $85.
Speculations with that kind of manageable risk to reward are few and far between, so particularly interesting here. Regardless, the current opportunity to exit exposure to these funds may not last long. So, carpe diem -- seize the day.