Best ETFs for falling interest rates: Top funds for when the Fed cuts rates

With the Federal Reserve signaling that it intends to cut interest rates when inflation has cooled sufficiently, investors have been on the hunt for investments that perform well in that climate. Many exchange-traded funds (ETFs) respond well to lower interest rates, and income investors may find that falling interest rates make it a particularly attractive time to invest in the market.

Here are some ETFs that may respond favorably to falling interest rates and what to know.

What investments perform well with falling rates?

The performance of an ETF depends on what it’s invested in. A fund that holds high-performing stocks will rise, while one with falling stocks will decline. So to understand which funds perform well while rates are falling, you must understand which assets perform well when rates decline.

In general, falling rates tend to be good for assets that generate cash flow, especially if that payout is fixed. The following assets tend to perform well when rates decline:

• Bonds: Bond prices move for many reasons, but one of the most important is changes in prevailing interest rates. And the longer the maturity of the bond, the more it’s affected by the change in rates. So long-term bonds move the most when rates are falling.

• Preferred stocks: Similar to bonds, preferred stocks typically pay a fixed return and can be redeemed. They also tend to fluctuate as the prevailing interest rate shifts.

• Dividend stocks: Dividend stocks typically pay out a quarterly dividend, which can grow over time. This kind of stock tends to do relatively better than an average stock when rates are falling, in part because the payout becomes more attractive.

• Real estate investment trusts (REITs): REITs invest in real estate, and falling interest rates push up the prices of real estate, all else equal. REITs also pay hefty dividends, so lower rates make those dividends more attractive, too. Plus, REITs also benefit because lower rates make it cheaper for them to borrow money, which they must do to operate.

It’s important to understand that the relationship between falling interest rates and rising asset prices is not one to one. Falling rates may happen during the early stages of a recession, when many asset prices are declining quickly. So buying the assets above doesn’t guarantee that you’re fully protected from a recession. But these investments may help soften the blow.

That said, falling rates should help prop up the price of bonds, preferred stocks and REITs in most scenarios except for a full-blown panic. But lower rates may only cushion the sting for dividend stocks, which may fall along with other stocks in a downturn or recession.

However, if investors see low rates as part of a “soft landing” – where the economy slows but doesn’t fall into a recession – the stock market as a whole may rally with lower rates, too.

Investors have already been pricing these scenarios into stocks and bonds since it became clear in the second half of 2023 that the Fed’s next move was likely to cut rates. So prices on some assets, such as bonds and preferred stocks, have recovered significantly already.

7 Best ETFs for when the Fed lowers rates

Here are some top fund candidates based on their holdings, returns and expense ratio.

iShares 20+ Year Treasury Bond ETF (TLT)

This fund owns exclusively long-dated U.S. Treasury bonds, with maturities of 20 to 30 years, so this fund will be quite responsive to changing rates.

Why it may perform well: If you think rates are going lower, this fund will likely move higher. But if rates rebound higher again, then this fund will likely decline from here.

Expense ratio: 0.15 percent

Goldman Sachs Access Treasury 0-1 Year ETF (GBIL)

This fund also holds U.S. Treasurys, but in this case it’s debt that matures in less than a year. It’s among the best ways to get the highest yields from current interest rates.

Why it may perform well: Yes, the yield on this fund will decline as rates decline, but you’re not enduring much principal risk to get it. If rates stay “higher for longer,” as the Fed says they will, you’ll continue to get that yield. The fund also offers optionality, meaning that if yields go too low you can take your principal and invest in something else that’s more attractive later, likely stocks.

Expense ratio: 0.12 percent

iShares 10+ Year Investment Grade Corporate Bond ETF (IGLB)

This fund owns long-term corporate bonds, meaning that it generally has a higher yield than similar Treasury bonds. The holdings here are investment-grade, making them of high quality.

Why it may perform well: This ETF should do well when rates fall, in particular because of the high-quality companies in the portfolio but also the strong current yield today and a razor-thin expense ratio, too. Of course, even if rates don’t move lower, you have that strong yield.

Expense ratio: 0.04 percent

Global X U.S. Preferred ETF (PFFD)

This ETF invests primarily in the preferred stocks of banks and utilities, offering up a healthy yield. It charges a very reasonable expense ratio and pays that dividend monthly, too.

Why it may perform well: If prevailing interest rates decline, the price of preferreds should rise, taking the value of this fund with it. Of course, if rates move higher, then the fund is likely to decline, but you’ll still be earning that strong yield.

Expense ratio: 0.23 percent

Virtus Infracap REIT Preferred ETF (PFFR)

This fund also invests in preferred stocks, but it offers up a higher dividend than the fund above because it owns higher-yielding securities issued by real estate investment trusts (REITs).

Why it may perform well: Preferred stocks issued by REITs typically have higher yields than those issued banks and utilities, but they also run higher risks. This fund will likely rise if the Fed lowers interest rates, though it could fall if rates rise. You’ll have to judge whether the extra-large monthly dividend is worth the extra risk, compared to the Global X fund and others.

Expense ratio: 0.45 percent

Vanguard High Dividend Yield ETF (VYM)

This fund owns high-yielding common stocks from proven dividend payers, including some of those among the Dividend Aristocrats, a group of stocks with a long record of rising payouts.

Why it may perform well: Falling rates may make dividend-paying stocks more attractive as sources of income, helping them outperform non-payers. However, common stocks tend to be sensitive, so a broader decline could send this fund and others lower despite the solid yield.

Expense ratio: 0.06 percent

Vanguard Real Estate ETF (VNQ)

This Vanguard fund owns REITs, a type of company that relies heavily on interest rates. In exchange for not paying tax at the corporate level, REIT stocks pay out strong dividends.

Why it may perform well: REIT dividends will look more attractive as rates fall, and lower rates will also help make it cheaper for REITs to finance their operations while making their properties more valuable. Of course, higher rates will do just the opposite to REITs.

Expense ratio: 0.13 percent

Bottom line

ETFs can be a great way to invest in a trend such as lower interest rates, allowing investors to quickly move into a diversified position without needing to analyze every single holding. The best brokers for stock trading can help you sort through the lot with strong research tools.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.