The investments to consider when interest rates fall

When I checked how funds on the Select 50 - a list of our favourite funds selected by experts - had reacted to the sudden sell-off on global markets, I found that almost every equity fund had fallen, whether it invested in Europe, Britain, the emerging markets or Japan. None of this is likely to come as a surprise to investors.

What may surprise you, however, is that when I checked on the performance of the Select 50’s bond funds, most had risen.

This simple exercise offers a couple of useful lessons.

First, it reminds us of the value of holding more than one kind of asset. If you have a mixed portfolio of shares and bonds, you will often see falls in the former offset to a greater or lesser extent by rises in the latter.

Second, it shows what tends to happen when fears of recession make interest rate cuts more likely. Recession and interest rate cuts to fight it are exactly what investors have started to expect in recent days as various economic data in America have undershot expectations.

Falls in interest rates make cash less attractive as an asset and to some extent that automatically makes all other assets more attractive, on a relative basis at least.

But the assets that benefit most directly from falling interest rates are bonds. Imagine that over some months a country cuts interest rates from 5% to 4%. In order to remain competitive with cash, bonds no longer need to yield 5% or more (the exact margin between cash rates and bond yields varies according to a number of factors that need not concern us here). Instead, it’s enough for them to yield 4%, give or take. For a bond’s yield to fall, its price has to rise as a hard rule of mathematics.

Not all types of bond benefit when rates are cut in response to recession fears, however. Broadly speaking, bonds issued by creditworthy governments and companies will tend to rise in price when interest rates fall, but those issued by less trusted borrowers may behave differently. In particular, when rates fall in response to fears of recession, investors may decide that weaker companies are more likely to go bust and that their bonds have therefore become riskier investments. As a consequence their prices fall and, again as a mathematical certainty, their yields rise. If you are interested in investing in bonds, you can see all bond funds on our Select 50 here.

Similar logic applies to a wide range of assets that have bond-like characteristics. Some shares are regarded by professional investors as ‘bond proxies’ because of the stability of their earnings; examples include utilities such as electricity suppliers and consumer goods companies. But other types of asset entirely also tend to offer a predictable income, such as commercial property and infrastructure assets. Private savers can put money into assets of this type via funds, typically listed funds or investment trusts because illiquid assets such as property are not suited to ‘open-ended’ funds that must offer investors the chance to redeem their holdings without notice.

The Select 50 list includes several funds that invest in property or infrastructure assets. Among the latter are First Sentier Global Listed Infrastructure, whose yield of 3.1% may not seem too attractive relative to cash rates of about 5% now but will become more appealing if interest rates do fall. Yields are not guaranteed, however. The fund is open-ended but avoids liquidity problems by investing in the shares of listed infrastructure companies (one holding is Britain’s National Grid) rather than in infrastructure assets themselves.

The one infrastructure investment trust on our list is International Public Partnerships, which yields 5.6%. The trust, which owns assets such as hospitals and care facilities, toll roads, railways and digital cabling, currently trades at a discount of 16.8% to the value of its assets.

There are two property funds on the Select 50. One is Balanced Commercial Property Trust, which yields 5% and currently trades at a discount of 17.3%. The other is a tracker fund, the iShares Environment & Low Carbon Tilt Real Estate Index Fund. This one is open-ended too and, like First Sentier Global Listed Infrastructure, invests in shares in quoted companies rather than directly in property. It yields 5.4%.

Property and infrastructure investment trusts can benefit in another way from interest rate cuts: they tend to have borrowed money, so falling rates should cut their interest bills. This does not apply to open-ended funds, however, because they do not borrow money.

The discussion above covers bonds and other income-producing assets. But what do interest rate falls mean for the broader stock market? The answer, unfortunately, is ‘it depends’.

If central banks were expected to cut rates simply because inflation had been brought under control, it would be unalloyed good news for most parts of the stock market (banks and insurers would be the main exception because they tend to prosper from higher rates). In this scenario, stocks should benefit, first, because of the fact, mentioned above, that a decline in the appeal of cash savings tends to make all other assets more attractive on a relative basis. This applies especially to shares that pay a dividend, even if they do not count as ‘bond proxies’. The second reason why falling interest rates tend to be welcomed by the stock market is that many companies borrow money, so falling rates reduce their interest bills and therefore make them more profitable.

But things are different if rates are being cut to deal with a recession. Here investors have to balance the positive effects of rate cuts against the damage likely to be done to corporate profitability by an economic downturn. If more central banks do cut rates over the coming weeks, some investors will see it as confirmation that central bankers do indeed expect a recession and may be even more inclined to sell shares as a result.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Overseas investments will be affected by movements in currency exchange rates.  There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to sell/cash in this investment when you want to. There may be a delay in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.