How to invest when rates are falling

Laura Bruce
The Fed rate cut isn't a signal to completely rejigger your portfolio but it can be an opportunity to consider investments that generally perform better as interest rates drop.

While lower rates often mean lower borrowing costs for businesses, a continually declining rate environment may mean that the economy is so soft that businesses aren't doing well, unemployment is rising and consumers are cutting back on purchases.

A portfolio that does well in those times may look bit different from one that does well when the economy is performing better. A few changes may be all your portfolio needs to keep it in the green.

We asked two portfolio managers for some ideas that do-it-yourselfers can consider when reviewing their portfolios.

Where to invest now

Bryant Evans: In his own wordsBryant Evans is a portfolio manager with Cozad Asset
Management in Champaign, Ill. He specializes in high-yield stock portfolios.

There are two very important things to keep in mind. You know rates have fallen recently, you don't know for sure they will continue to fall. You need to consider what you think rates will do going forward because that's what really matters when it comes to investments.
The other thing is: What does the yield curve look like? If we go with the assumption rates will continue to fall -- and that's not a bad assumption when the economy looks like it's weakening a little bit -- there are certain kinds of investments that do very well, especially short- to midterm Treasury bonds.

As rates go down prices go up and bonds tend to do quite well in a falling-rate environment. But this leads to that question about what will happen going forward. If you get in now and rates continue to go down, you're in good shape. But let's say we're at a historically low rate and they start rising again. Well, those same investments -- short- to mid-term Treasuries -- are not a good place to be.

Let's remember that good investors think well beyond the current interest rate cycle. If you have a good diversified bond portfolio or a laddered strategy, you'll be fine. Diversification and a long-term outlook will mitigate the short-term effect of market and rate fluctuations.
How to diversify in bondsYou can diversify into different kinds of bond funds. Diversified bond funds are often called "total return funds." I like them for someone who doesn't have a lot of money to invest and wants diversification. If you can diversify by investing in two different kinds of bond funds, then you might avoid the total return fund and build a portfolio of bond funds. Think long-term and mix and match. You might have a floating-rate bond fund as well as an inflation-protected fund with Treasury Inflation-Protected Securities or TIPS. Just in case we're at a historic low and rates are going to start coming back up, those tend to do OK as rates rise. Then mix in some Treasuries and some high-yields and some municipal bonds.

Utility stocks usually upOften times when the Fed is reducing rates, the stock market does very well. The reason doesn't have much to do with the rates per se and what's going on in the bond market, the reason is because people think the Fed is making the right move to improve the economy down the road. A strong economy is very good for stocks, but may not be very good for bonds. If rates are going down, the bond market will do well, almost regardless of whatever else is going on.

There are certain kinds of stocks that tend to do well in a low interest-rate environment. One group is utilities. Utilities are high-yield in nature and compete a little bit with bonds. When bond rates are rising, utilities don't do so well. But money starts moving into them as bond rates go down because the dividend you get off utilities tends to increase year over year regardless of fixed income.

There's another aspect. Relative to other stocks, utilities on average carry fairly large debt loads. They're always borrowing money, so part of their cost of doing business is paying interest on their loans. So if rates are down, their costs go down.

REITs may be rightWe might talk a little about real estate investment trusts as income. REITs have come down; even the ones that are taking advantage of problems in the housing market, such as apartment REITs, have been thrown out with the bath water. They're actually looking quite attractive right now. They also tend to carry big debt because they borrow to finance new acquisitions, and they tend to do well in a falling-rate environment. Add in the factor that a falling-rate environment is often highly correlated with a falling broader economic environment.
REITs have a safety effect to them relative to other stocks because their income is fairly reliable. If you go back to 2001 through 2002 when the stock market was getting hit, REITs really held up well. I like commercial and industrial but especially apartment REITs.
Put money on financial servicesIn addition to utilities and REITs, I would also say, in general, finance companies do well in a low-rate environment. We're in a weird time for finance companies. Banks are getting hit, everything's getting hit by the mortgage problem, but lower rates going forward will help to save these companies. So, to me, their valuations are looking pretty attractive.

Consumer staples, not to be confused with consumer discretionary, also tend to do pretty well in a slowing economy.

ARM holders benefitIf you have an adjustable-rate mortgage, you should be considering refinancing. A falling-rate environment is a lot better for ARM holders, but mortgages are long term. A lot of people are enticed into ARMs with artificially low beginning rates. Those are the ones that are going to ratchet up regardless of what happens with the Fed. Those are the people who really need to think about getting a fixed-rate loan.

As a general rule, if you have a mortgage and you can get a rate that's about 1 percent better, it's a pretty good time to refinance. That's a very general rule because it depends on how many years you have left, and it assumes you can be efficient in terms of minimizing closing costs.
Diversification and a long-term approach are incredibly key variables and investors who focus on the short term nine out of 10 times are the ones who don't do very well and end up frustrated.

You have to be a little bit brave, but brave investors capture value because some short-term problem is making companies look unattractive.

Jeff Layman: In his own wordsJeff Layman is director of investment services at BKD Wealth Advisors in Springfield, Mo.

Effectively we've been in a declining-rate environment in terms of market rates even (before the Fed cut the federal funds rate). Bond market yields have come down to reflect the anticipation that the Fed will be busy.

That, in our view, makes stocks more attractive on a relative basis than the yields available on bonds. We feel that the starting point for stocks is pretty attractive at a little over 15 times this year's earnings estimate. The Fed rate cut should help this along. Stocks benefit in multiple ways from a lower interest rate environment, so we think stocks, generally, will look even more attractive than they do right now.

With interest rates and inflation even at current levels, a 15 multiple is pretty cheap. Fifteen times earnings or 16 times earnings is generally where we've been trading for the last few months. We feel like a federal funds rate cut would increase the chance we might get a little multiple expansion between now and the end of the year. We're not talking about up to 20 times earnings, but even to 17 or 18 times earnings if there was enough optimism about how those rate cuts might improve the outlook for 2008. And that would really give a nice boost to the total return for equities this year too.

What's a stock worth today?The other thing that's very important with lower interest rates is looking at the valuation of equities and what they're worth today; that present value of their future earnings stream is an important thing to look at. That becomes a bigger number the lower interest rates go. In other words, the future earnings are worth more today in a lower interest rate environment than they are in a higher interest rate environment.
Obviously, lower interest rates lower the cost to borrow for corporations, which, all things being equal, ought to help their earnings potential as well. And as important, the thing that's been very concerning to the market over the last several months is how will consumers do in this environment? Will they stay engaged in the economy? They drive two-thirds of the spending. It's been a little spotty but, generally, they've hung in there pretty well, but the consumer's been a big concern to investors. To the extent that the cost of borrowing comes down and also the availability of credit -- that's the other thing we've been keeping an eye on -- the extent that credit is available and reasonably priced and helps them stay engaged in the economy that would be a positive as well.

Dividends may pay off

Dividends are nice, but we don't really look at them as the end all as far as attractiveness. But if you could find good-quality companies that pay nice dividends -- the financial stocks are pretty good examples of that right now, in that they've been beaten up a bit right now irrespective of the amount of subprime mortgage exposure they have. You can find banks that in some cases are in the range of nine or 10 times earnings with dividend yields of 3 percent or greater. We think that looks like a pretty good investment opportunity over the next few years, knowing that there's going to be more negative news about subprime for some time.
What about bonds?Total returns from bonds have improved in the last couple months as rates have come down, so if you're an existing bond fund holder you should have done pretty well. For the new entrant looking to make a purchase of a bond fund, the only thing I can suggest is that rates are now back down in the Treasury market to as low as they've been in some time, so the prices have been pushed up. We don't particularly look at now is this a great opportunity to buy a bond fund. For just raw opportunity it still offers a good diversification benefit, but we think the return opportunity is going to be somewhat limited in general.

The typical individual investor may not realize that (the Fed rate cut) has really already been reflected in the bond market with prices going up and yields coming down the last few weeks. That doesn't necessarily mean good things will happen to your bond fund investment; in fact, not much might happen at all.

The market has priced in about 75 basis points of future Fed cuts through March of next year; so, over the next six months or so 75 basis points of cuts. Do they go further than that? That will play out but that's what the expectations are that are built in right now.
Real estate, another major investable asset class, didn't start to roll over because of higher rates; it was that prices got ahead of themselves in a lot of commercial and residential properties around the country. We think that that's not necessarily going to be helped by small Fed rate cuts on the front end. I think it will take a little longer to work out, so we're not really particularly active in real estate or REITs right now.

Stocks are tops

Equities are still our favorite place to be. We find lots of value in a lot of areas, particularly the large-cap U.S. market. Growth is a lot more attractive in our view right now. We like the health stocks and technology stocks; they're coming along pretty nicely this year after several years of underperformance as well.

“Equities are still our favorite place to be.” I think we'll have a bumpy ride in financials, but we have been allocating new dollars there. Some of the stocks have really come down and can be bought at attractive valuations, but we're paying a lot of attention to the amount and type of exposure they have to the worst-performing part of the loan market because it will take some of these companies a long time to recover. Some of the others don't have a lot of exposure and have probably been over-punished. I don't expect they'll have a big run between now and end of year, but they represent a pretty good value over the next couple of years.


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