In March 2022, the Federal Reserve, under the leadership of Chair Jerome Powell, embarked on a series of interest rate increases to combat the post-pandemic inflation that threatened the economy. Unfortunately, inflation proved to be a stubborn phenomenon. Since then, the Fed has increased rates 11 times. Banks and other creditors followed suit, increasing rates on everything from credit cards to personal and business loans to home and commercial mortgages. Rates that governments and corporations pay to borrow money by issuing bonds also increased dramatically.
Almost two years later, higher rates seem to have had the desired effect. After peaking at 9.1% year-over-year inflation in June 2022, the most-recent reading fell to 3.1% for November. That’s still above the Federal Reserve’s target of 2%, but, clearly, progress has been made.
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Despite strong economic growth and healthy job creation, inflation appears to be waning. The Fed has paused its policy of rate hikes since July. On Dec. 13, the Fed indicated that it may start cutting rates next year, with at least three possible cuts in 2024. As of this writing, the CME FedWatch Tool showed that markets expect the first cut to come at the Fed’s March 20 meeting next year.
Rate cuts, as opposed to rate hikes, call for a different approach to investing. Here are some investments to think about when interest rates inevitably begin to come down:
— High-yield investments.
— Bond ETFs.
— Preferred stock.
— REITs.
— Housing stocks.
High-Yield Investments
Conservative, income-oriented savers should consider locking in the current high rates by purchasing certificates of deposit (CDs) or government bonds.
With a little shopping around, it’s easy to find 12-month CDs offering significantly more than 5% annual percentage yield, or APY. Depositors can’t make withdrawals during a CD’s term, but they will generally earn more than they would in a savings or money market account, and their principal will not decrease if the stock or bond markets fall.
U.S. government bonds, or Treasurys, can be purchased in a brokerage account or directly from the Treasury at TreasuryDirect.gov. As of this writing, the yield on a six-month Treasury bill (T-bill) stands at 5.3%, with interest and principle backed by the full faith and credit of the U.S. government. The price of longer-term government bonds will fluctuate with changes in interest rates but, if held to maturity, they are considered extremely safe.
No one can say exactly when rates will peak, but if you think — as many experts do — we are at or near the top of the rate cycle, and you appreciate guaranteed, predetermined rates of return, a CD or a government bond is worth looking into.
Bond ETFs
Bonds are fixed-income securities that tend to go down in value when rates are rising and tend to go up when rates are going down. Predictably, bond exchange-traded funds, or ETFs, have performed poorly over the past couple of years as rates were rising.
Without making predictions on the timing of future rate cuts, one can’t be faulted for assuming that if rates are poised to go down, bond funds are set to rise. A bond ETF is a convenient way to invest in a diversified portfolio of corporate or government bonds, or a combination of both.
With $102 billion in assets, Vanguard Total Bond Market ETF (ticker: BND) is one of the largest bond ETFs on the market. With its low 0.03% expense ratio and the current interest-rate outlook, BND is garnering a lot of attention from retail and institutional investors. BND invests in a broad selection of investment-grade bonds that have a minimum maturity of one year. The ETF has a 12-month yield of 3.08%.
Investors who prefer the relative safety of government issues can consider the iShares 20+ Year Treasury Bond ETF (TLT), which invests in long-term government securities, or the SPDR Portfolio Short Term Treasury ETF (SPTS), which sticks to short-term bonds. Keep in mind, however, long-term bond ETFs will tend to fluctuate more — both up and down — with the interest rate market.
[SEE: 9 of the Best Bond ETFs to Buy Now.]
Preferred Stock
Preferred stocks are not the same thing as bonds, but they are income securities and share characteristics that make them attractive when rates are falling. Specifically, they have an inverse relationship with the general direction of rates, meaning, like bonds, preferred stocks generally go up when rates fall.
A preferred stock trades like common stock, but investors in preferred securities don’t get voting rights. What they do get is an enhanced dividend income and preferential treatment in the event of a company default or bankruptcy. This puts them in the fixed-income investment category. As we’ve seen, fixed-income securities can do very well when rates start to drop.
The price and dividends associated with preferred stocks is only as good as the company behind them. There are investment-grade preferred stocks as well as “junk” preferred stocks. Investors interested in the income and capital appreciation potential of this asset class may want to use a professionally managed mutual fund or preferred stock ETF rather than attempt to pick their own.
The First Trust Preferred Securities & Income ETF (FPE) is one example of a popular preferred ETF. It is an actively managed ETF with $5 billion in assets under management. The fund is concentrated in securities from the banking, insurance and energy sectors, and it yields 6.24%.
The Nuveen Preferred Securities & Income Fund (NPSAX) is an example of an open-ended mutual fund that invests in preferred stock. The fund has a 5.74% yield and $4 billion in assets.
REITs
When interest rates are falling, dependable, regular income investments become harder to find. This benefits high-quality real estate investment trusts, or REITs.
Strictly speaking, REITs are not fixed-income securities; their dividends are not predetermined but are based on income generated from real estate. Still, in a general sense, they are income securities and do trade like income securities. You can usually count on high-yielding REITs moving up when rates are moving down.
Individual REITs like Realty Income Corp. (O) and Digital Realty Trust Inc. (DLR) have been mostly out of favor as rates spiked, but both have been moving up nicely in recent months, as investors anticipate falling rates.
The same can be said of the iShares Cohen & Steers REIT ETF (ICF) and other funds in that category.
Housing Stocks
Recent high mortgage rates put homeownership out of reach for many homebuyers. If mortgage rates fall, which they will do if the Fed cuts rates, the cost of buying and furnishing a new or existing home will fall, and more buyers will enter the market.
It’s reasonable to expect big home builders such as Toll Brothers Inc. (TOL) and KB Home (KBH) to do well as the residential housing market expands. Rental housing companies like Invitation Homes Inc. (INVH) stand to benefit as well.
In addition to companies that build and own residential real estate, big-box home retailers such as Home Depot Inc. (HD) and Lowe’s Cos. Inc. (LOW) are well positioned to prosper in a falling rate environment.
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How to Invest When Interest Rates Are Cut originally appeared on usnews.com
