As the Federal Reserve signals its intention to lower interest rates once inflation has cooled, investors are seeking out investments that thrive in this environment. Many exchange-traded funds (ETFs) perform well when interest rates are falling, making it an attractive time for income investors to enter the market.
Here are some ETFs that are likely to benefit from declining interest rates and what you need to know about them.
Which investments excel in a low-interest-rate environment?
The performance of an ETF is closely linked to its underlying assets. Assets that generate cash flow, especially if the payout is fixed, tend to perform well when interest rates are falling. Here are some investments that typically thrive in this scenario:
- Bonds: Long-term bonds are particularly sensitive to changes in interest rates. When rates decline, the prices of long-term bonds tend to rise.
- Preferred stocks: Similar to bonds, preferred stocks usually offer a fixed return and can be redeemed. Their prices also fluctuate in response to changes in interest rates.
- Dividend stocks: Stocks that pay out regular dividends, which may increase over time, become more attractive when rates are falling.
- Real estate investment trusts (REITs): REITs invest in real estate properties, and lower interest rates can boost real estate prices. Additionally, REITs pay out substantial dividends, making them more appealing when rates are low. Lower rates also reduce borrowing costs for REITs, enhancing their profitability.
It’s important to note that the relationship between falling interest rates and rising asset prices is not always straightforward. During the early stages of a recession, many asset prices may decline rapidly, despite the overall decline in interest rates. While investing in the mentioned assets can provide some protection during a downturn, it does not guarantee immunity from a recession.
However, falling rates typically support the prices of bonds, preferred stocks, and REITs, except in extreme scenarios. Dividend stocks may experience a decline along with other stocks during a recession. If interest rates decline gradually without leading to a recession, the overall stock market may see a positive impact from lower rates.
Investors have already factored in these scenarios into stock and bond prices since the Federal Reserve hinted at potential rate cuts in 2023. Consequently, prices of assets like bonds and preferred stocks have already rebounded significantly.
Top 7 ETFs for a declining interest rate environment
Here are some top ETF options based on their holdings, returns, and expense ratios.
iShares 20+ Year Treasury Bond ETF (TLT)
This ETF exclusively holds long-dated U.S. Treasury bonds with maturities ranging from 20 to 30 years, making it highly responsive to interest rate changes.
Reasons for potential performance: If interest rates continue to fall, this ETF is likely to see price appreciation. However, a rebound in rates could lead to a decline in its value.
Expense ratio: 0.15%
Goldman Sachs Access Treasury 0-1 Year ETF (GBIL)
This ETF invests in U.S. Treasurys with maturities of less than a year, offering attractive yields based on current interest rates.
Reasons for potential performance: While the yield may decrease as rates fall, the fund provides stable returns with minimal principal risk. It also offers flexibility to shift investments if yields become unattractive.
Expense ratio: 0.12%
iShares 10+ Year Investment Grade Corporate Bond ETF (IGLB)
This ETF focuses on long-term investment-grade corporate bonds, offering a higher yield compared to Treasury bonds of similar duration.
Reasons for potential performance: With high-quality holdings and a low expense ratio, this ETF is well-positioned to perform well in a falling rate environment. It provides a strong current yield even if rates remain stable.
Expense ratio: 0.04%
Global X U.S. Preferred ETF (PFFD)
This ETF primarily invests in preferred stocks of banks and utilities, providing a healthy yield with a reasonable expense ratio.
Reasons for potential performance: If interest rates decline, the value of preferred stocks is likely to rise, benefiting this fund. However, an increase in rates may lead to a decrease in its value.
Expense ratio: 0.23%
Virtus Infracap REIT Preferred ETF (PFFR)
This ETF also invests in preferred stocks, focusing on higher-yielding securities issued by real estate investment trusts (REITs).
Reasons for potential performance: REIT-issued preferred stocks typically offer higher yields but come with increased risks. This fund is likely to appreciate if interest rates drop, although it may face declines if rates rise. Investors should weigh the higher dividend against the additional risk compared to other funds.
Expense ratio: 0.45%
Vanguard High Dividend Yield ETF (VYM)
This ETF holds high-yielding common stocks from established dividend-paying companies, including Dividend Aristocrats with a history of increasing payouts.
Reasons for potential performance: Falling rates can make dividend-paying stocks more attractive as income sources, potentially outperforming non-dividend-paying stocks. However, common stocks are sensitive to market fluctuations, so a broader market decline could impact this fund’s performance despite its attractive yield.
Expense ratio: 0.06%
Vanguard Real Estate ETF (VNQ)
This Vanguard fund invests in REITs, which heavily rely on interest rates. REIT stocks pay substantial dividends as they are not taxed at the corporate level.
Reasons for potential performance: Lower rates make REIT dividends more appealing, while reduced borrowing costs and increased property values benefit REITs. Conversely, higher rates could negatively impact REITs.
Expense ratio: 0.13%
Conclusion
ETFs offer a convenient way to invest in trends like declining interest rates, allowing investors to diversify their portfolio without extensive research. Leading stock trading brokers can assist in navigating the market with robust research tools.
Editorial Disclaimer: Investors should conduct their own research before making investment decisions. Past performance does not guarantee future results.