Will lower interest rates hurt these funds?

Rising interest rates since late 2021, with the Bank of England taking its base rate from 0.1% to 5.25%, caused stock and bond markets to fall in tandem. But not all assets were negatively affected by the higher cost of money.  

Among the “winners”, or at least not the losers from rising interest rates, were investment areas such as value shares, floating rate bonds where returns link to interest rates, and commodities. 

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For example, during 2022, which was one of the most difficult periods for stock and bond markets, the Bloomberg Commodity Index rose 30%. That year, the FTSE 100, which is packed with dividend-paying, lowly valued shares in the financials and resources sectors, returned 5%. A bond market winner was iShares $ Floating Rate Bond ETF USD Dist GBP (LSE:FLO5), which rose 14% during 2022.  

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Kamal Warraich, head of fund research at wealth manager Canaccord Genuity, explains: “Anything that was generating a lot of cash, like high-dividend yield stocks, performed well.  

“When the discount (or safe interest rate) goes up, you want high-yielding assets. Rates going up quickly meant there were not many places to hide. Anything with cash flows in the future suffered.” 

Higher commodity prices meant that oil and gas, and mining companies, also performed well, while banks profited from higher returns on their cash deposits, according to Warraich.  

In contrast, companies with profits promised way out into the future, such as expensive technology shares, fell as rates rose. Also, companies considered “bond proxies” due to steady cash streams, such as infrastructure and property, were also among the biggest casualties. This was because future returns from fixed income rose as interest rates rose, making bond alternatives relatively less desirable.

But will the reverse also be true now that the Bank of England has begun cutting interest rates?   

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“Economic theory says that the winners and losers are reversed,” says Warraich.  

Some of this will already be in market prices, such as a recovery this year in small-cap assets and technology shares, but there will still be a move when interest rate cuts actually take place, according to the fund analyst.  

“There has not been a full recovery yet, but green shoots are emerging in utilities, infrastructure, and bond-like assets, such as consumer staples. Rates coming down could trigger moves upward for these sectors, but technology could have got carried away with the artificial intelligence theme,” he said.  

The outcome for sectors that performed better during periods of rising rates is less clear now that rates are coming down. Warraich thinks that value shares still deserve a place in portfolios. 

“A more core value proposition could still do well if you are buying good companies. A lot will depend on commodities and banking exposure, which are the sectors that could suffer the most as rates fall. So investors need to be selective about not going into companies that are too cheap,” he said.  

He also points out that interest rates are not going to drop back to near-zero, and a 3.5% rate may be the neutral level that central banks settle on. In this scenario, reversals in the fortunes of different sectors won’t be as extreme as during the period of rising interest rates.  

“Investors should remain diversified by style, so you can profit from rotations. Interest rates don’t govern everything,” Warraich says.  

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Commodities are a “neutral” call currently for Joost van Leenders, a senior investment strategist at Van Lanschot Kempen.  

He says that worse-then-expected economic growth data is putting pressure on commodity prices, but the defensive nature of gold can enable it to avoid the same fate.  

“Oil markets are tight and stocks low, but the knowledge that the OPEC countries have sufficient production capacity and are being sensible about this restricts the upward potential for oil prices.  

“The downturn in metal prices is remarkable. It tells us something about the speculative nature of previous price increases for some metals but also about the doubts that investors have about the global economy,” he said.  

What funds to buy 

With interest rates falling, equities that did poorly when rates rose could now perform best. 

“We think they will bounce back, so we have been buying UK small and mid-cap assets, but keeping our UK allocation overall at the same level. We feel we are at the beginning of a bigger recovery in UK small and mid-cap shares,” Warriach said.  

One way he accesses this sector is via Slater Growth, a UK equity fund run by Mark Slater.  

Warriach still has exposure to value shares, such as via Fidelity Special Situations , but is balancing this with some high-quality stock as well, such as those in the consumer staples space, via Evenlode Global Equity. 

In bonds he is neutral from an asset allocation perspective, but prefers corporate bonds over government bonds. Corporate bonds generally yield more than government bonds, but come with greater default risk.  

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Bond funds he likes include TwentyFour Focus Bond and Jupiter Strategic Bond. 

Another fan of bond funds as interest rates fall is Eduardo Sanchez, of fund research firm Square Mile.  

He says that fixed-income funds with a bias towards long-duration assets are likely to benefit, as well as those that adopt a dynamic investment approach, which enables their managers to exploit short- and long-term market opportunities. 

Sanchez says Aegon Strategic Bond and Janus Henderson Strategic Bond fit the bill, as they both have a flexible mandate to take advantage of falling interest rates.