On Sept. 12, the European Central Bank announced that, for the second time in three months, it was cutting its key interest rate. While the move was not altogether unexpected — economic growth in the eurozone has been increasingly sluggish and inflation has been slowing — it did reinforce the belief that the U.S. Federal Reserve would soon embark on a similar program of rate cuts. World financial markets now widely expect the Fed to announce a cut of at least 25 basis points at its next meeting on Sept. 18.
[Sign up for stock news with our Invested newsletter.]
Businesses, consumers and investors generally welcome the prospect of falling rates. Interest rates represent the cost of capital. Lower rates on business loans, bonds, credit cards and mortgages mean more economic activity and faster economic growth, which can translate into higher corporate earnings and a bullish stock market.
Almost all industrial sectors will benefit from rate cuts to one extent or another, but some sectors and some asset classes do particularly well in falling interest rate environments. In other words, the rate cuts on the horizon call for a new and different approach to asset allocation and security selection.
Here’s how to invest and what to invest in when rates are dropping:
— Bonds and bond funds.
— Real estate and housing.
— Preferred stock.
— Financials.
Bonds and Bond Funds
Bonds are also known as fixed-income securities. That’s because most bonds pay an unchanging, or fixed, interest income until they mature sometime in the future. By their nature, bonds that were issued during periods of higher rates pay higher interest, which is locked in until they mature. When rates fall, previously issued, higher interest bonds become more valuable in relation to new ones, which pay a lower income. What that means is that when the general level of interest rates goes down, the general level of bond prices goes up because the ones already on the market pay more and are thus more valuable.
Investors who can afford to be aggressive might want to take a look at high-yield bonds, often called junk bonds. While buying individual high yield bonds is not recommended for most retail investors, there are many professionally managed, diversified bond funds to consider.
One such fund is the $13 billion, open-ended Fidelity Capital & Income Fund (ticker: FAGIX). It’s true that FAGIX invests in low-credit-quality bonds, but Morningstar rates it five stars and it is well diversified. FAGIX has a 12-month trailing yield of 5.5% as of Sept. 13, and it may provide substantial capital appreciation as rates drop.
Investors who want the higher yields associated with corporate bonds, but don’t want to venture into junk bond territory, should look to a quality corporate bond ETF such as the iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB). The fund has $21 billion in assets and a low expense ratio of just 0.04%. It’s a solid choice when interest rates are being slashed. The fund has a healthy 12-month trailing yield of 3.7%.
Conservative investors will find U.S. government bonds attractive. Most brokerage platforms make it easy to buy government bonds, and because their interest and principal are backed by Uncle Sam, it’s hard to make a mistake when choosing individual issues. If, however, you don’t want to sift through your broker’s inventory to find an individual Treasury bond, there are hundreds of excellent funds and ETFs.
One popular, low-cost choice is Vanguard Intermediate-Term Treasury Index Fund ETF (VGIT). This index fund invests in Treasury securities with remaining maturities of between three and 10 years. Its 12-month trailing yield is 3.3% and the expense ratio is just 0.04%.
[7 Best Data Center Stocks, REITs and ETFs to Buy Today]
Real Estate and Housing
When the fed funds rate falls, rates on residential and commercial mortgages are sure to follow. This is usually good news for real estate investment trusts (REITs), homebuilders and home improvement retailers. As real estate — both residential and income-producing — becomes less expensive to own, the economy will see more development, more big commercial real estate deals and more single-family home sales, all of which bodes well for real estate and related fields.
A REIT like Invitation Homes Inc. (INVH) should do particularly well as rates go lower. It buys, rehabs and rents out single-family homes and will benefit greatly from lower commercial mortgage rates. INVH currently pays a forward annual dividend of $1.12 a share, which translates to a 12-month trailing yield of 3.1% based on its Sept. 12 closing price.
Big-box home improvement giants Home Depot Inc. (HD) and Lowe’s Cos Inc. (LOW) should see sales and profits increase if a drop in residential mortgage rates releases pent-up demand and causes a housing boom. Right now could be a great time to buy either of those retailers.
The same can be said for the $15 billion home building firm Toll Brothers Inc. (TOLL) or its $28 billion counterpart PulteGroup Inc. (PHM). Or, for investors who appreciate more diversification than individual stocks can offer, the $2 billion SPDR S&P Homebuilders ETF (XHB) may be more appropriate.
Preferred Stock
Preferred stocks share some important attributes with bonds. Particularly the fact that they usually pay a fixed income over their lifetimes. In other words, the same dynamics that make bonds skyrocket when rates plummet also drive up the price of preferred securities.
The value of a preferred stock mostly depends on its credit rating, which can range from junk bond status to high investment grade. Furthermore, every preferred stock is issued with its own prospectus that can contain complex provisions and features. All of which is to say, picking individual preferred issues is best left to professional asset managers. Retail investors who want to take advantage of the high yields and growth potential associated with this asset class should stick to ETFs.
One fund to consider along those lines is the Invesco Preferred ETF (PGX). This $4 billion ETF provides shareholders with a current 12-month trailing yield of 5.9%. The fund mirrors the ICE BofAML Core Plus Fixed Rate Preferred Securities Index and offers excellent diversification across industrial sectors.
Another one to look into would be the SPDR ICE Preferred Securities ETF (PSK). PSK also tracks an index — the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index — but it includes adjustable-rate preferred stock along with fixed-rate selections and, therefore, delivers a somewhat higher yield. The 12-month trailing yield for PSK is currently 6.2%.
Financials
Capital is the lifeblood of the financial sector. It stands to reason that as the cost of capital goes down, financial firms such as insurance companies, asset managers, credit card companies and investment banks will benefit greatly.
Investors may want to consider owning the world’s biggest asset manager, BlackRock Inc. (BLK). Because of its sheer size, that $131 billion mutual fund, ETF and private equity giant stands to benefit more than all of its other peers in the financial industry.
Investors looking for professional management and a high level of diversification should check out the $917 million Fidelity Select Brokerage & Investment Management Fund (FSLBX). That fund is managed by Boston’s Fidelity Investments and should experience significant growth in the coming months as rates fall.
Incidentally, regional and national banks and bank funds do not benefit from rate cuts to the same extent as brokers, asset managers and insurance companies do. Banks are very limited as to what they are allowed to invest in. As a result, they often see their profits squeezed when rates head lower. If you are interested in bank stocks, choose one with diversified and wide-ranging business lines. JPMorgan Chase & Co. (JPM), for example.
More from U.S. News
7 Best Investments During a Recession
7 Best Monthly Dividend ETFs to Buy Now
7 of the Best Tax-Free Municipal Bond Funds
How to Invest When Interest Rates Are Cut originally appeared on usnews.com
Update 09/13/24: This story was previously published at an earlier date and has been updated with new information.
