How to Invest When Interest Rates Fall

Takeaways

• Be prepared to take more risks with your fixed-income investments

• Some types of stocks are good to buy when rates fall

• Find out which types of options trades can generate extra income

• Commodities can be a good alternative

Stay the course

Bond prices and interest rates always move inversely with one another. When interest rates fall, bond prices rise. This means that the value of the fixed-income holdings in your portfolio will increase as rates drop. You may therefore be tempted to sell some of these holdings to profit from their growth. But this course of action could backfire.

You will immediately reap a capital gain when you sell, but then you must reinvest your money into something else. And if rates have fallen, you will get a lower interest rate on your new investment than what you had before.

You may be wise to just hold on to your current investments and wait for them to mature. It all depends upon your cash flow needs and investment objectives. If you do not need the interest income to live on, then selling may be a good idea. But do not act rashly just because rates are falling. You need to stick to your long-term investment plan regardless of market conditions.

Lock in your investments for the long term

If you are looking to maintain a stable cash flow for the foreseeable future, then buying longer-term fixed-income holdings is a good idea. This way you can lock in a higher rate and won't have to worry about where rates go from here. If you've been investing in T-Bills, consider buying some T-Notes or T-Bonds to ensure that your cash flow remains the same.

How to invest when interest rates fall: Take more risk

If you want the income level from your investments to stay the same, then you will have to look to slightly more aggressive types of fixed-income investments. Consider investing in alternatives such as REITs, limited partnerships, preferred stocks, junk bonds, or junk bond mutual funds. These investments are not as safe as Treasury securities, but they will pay higher rates of interest.

Another possible investment is a mutual fund that invests in senior secured corporate loans. This type of fund usually pays a percent or two more than certificates of deposit or other more conservative holdings. These are some easy things you can do to prepare your portfolio for falling interest rates.

Write covered calls

If you own individual stocks, then you could bolster your income by writing covered calls on them. This will generate additional passive income from your portfolio. Just be sure to keep your strike prices far enough away from the current market price so that you do not get called out. You can also write covered calls on most exchange-traded funds.

Sell naked puts

If you have your eye on a particular stock and want to buy in when it reaches a certain price, then you could sell naked puts on the stock until it reaches your price, and collect the premiums in the meantime. This is a common strategy used by veteran institutional traders and investors to increase their investment income and overall returns. As with covered calls, you can also sell naked puts on most exchange-traded funds.

How to invest when interest rates fall: Buy utility stocks

Utility stocks tend to hold up well when interest rates fall because of the relatively stable demand for their services. They also usually pay high dividends, which can increase your current income. If you want to capitalize on the rising price of one or more of your fixed-income holdings, consider selling them and buying some utility stocks. This could preserve your current level of income and give you a short-term gain as well. Utility stocks stayed in a very stable price range in 2008 when the Fed reduced rates very quickly.

Buy healthcare stocks

The healthcare industry is another sector that is relatively immune from falling interest rates. The demand for healthcare is very stable and they also often pay competitive dividends. As a result it is rare for investors to do a sector rotation away from it. Pharmaceutical stocks in particular can provide a source of stable income plus some capital growth over time.

Buy consumer staples stocks

When interest rates fall, consumers are left with more money to spend because their credit card balances and other types of debt become cheaper. This means increased revenue for department stores and other retail outlets which can translate into dividends and capital gains for shareholders.

How to invest when interest rates fall: Buy commodities

The futures market has zero correlation with the stock and bond markets. But when interest rates fall, the U.S. dollar weakens relative to other currencies. This boosts commodity prices and can help you to make a profit within a relatively short time. You can also buy the stocks of commodity producers such as oil and gas companies. Gold mining companies and companies that produce various types of metals are also good targets. But buying futures contracts on the commodities themselves may be the best way to go. If you do this, then you do not have to worry about such factors as whether the producers of the commodity are being managed competently or other issues. You may also want to consider buying precious metals such as gold, which typically rise in value when the markets are down.

Buy preferred stocks

Although they do no't have voting rights as common stocks do, preferred stocks have been a reliable source of regular income for investors for decades. Preferred shares tend to remain relatively stable in price and usually pay dividends that are a percent or two above what guaranteed instruments can offer.

While preferred stocks are obviously not guaranteed to return your principal, their risk reward ratio can be very appealing. Those who are willing to venture beyond certificates of deposit and Treasury securities can boost their incomes with preferred offerings.

Refinance your debt

Falling interest rates are not all bad. While they can have a negative impact on the market, they also mean that debt gets cheaper. Wait until rates have fallen by a percentage point or so and then go to your home lender and refinance your mortgage. Any reduction in your investment income can thus be offset by having a lower mortgage payment.

You can also refinance your car loans and possibly your student loans as well. You can lock in your savings for the long term with a fixed-rate loan. Or, if you think rates will go still lower, you can get an adjustable-rate loan. Then you can be assured of your payment going down as far as rates drop.

How to invest when interest rates fall: Peer-to-peer lending

Lending your money to a prospective borrower can provide you with an excellent rate of return. Peer-to-peer lending websites match borrowers with individuals willing to lend their money for a price. But you will need to be careful because some lending sites are much riskier than others. For example, you can charge an interest of 20%, but the borrower may default on the loan. If this happens, then you can lose some or all of your investment.

Conclusion

Although inflation is what economists focus on with consequent interest rate rises, you should be aware that interest rates can fall too. These are just some of the ways that you can take advantage of falling interest rates. But the strategies listed here can give you a good start to preparing your investment portfolio for falling interest rates. Do not wait for rates to fall any further before implementing the ones that will benefit you the most.