The investments to consider when interest rates fall

Last week the Bank of England cut its official interest rate from 4.5% to 4.25% and financial markets expect more reductions this year. While the effects of interest rate cuts on mortgage borrowers and savers are most obvious, interest rates also have a huge, but perhaps under-appreciated, influence on the stock market and other investments. Here we explain the reasons and identify the assets that tend to do well when rates fall. 

The first thing to happen when the Bank of England cuts interest rates is that banks and building societies follow suit and reduce the interest they pay on savings accounts. A fall in interest rates makes cash less attractive and to some extent that automatically makes all other assets more attractive, on a relative basis at least. 

• Read: How far will interest rates fall?

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: the yield is the annual interest payment divided by the bond’s price.

• Read: Your 10 most-asked bond questions, answered

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 browse the list of bond funds that belong to Fidelity’s Select 50, our recommended funds chosen by independent analysts.

Similar logic applies to a wide range of assets that have bond-like characteristics. Some shares are regarded by professional investors as proxies for bonds because of the stability of their earnings; examples include utilities such as electricity companies and suppliers of essential consumer goods. But other investment types 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 assets such as property take time to sell (they are ‘illiquid’) and are therefore not suited to ‘open-ended’ funds that must offer investors the chance to redeem their holdings without notice.

Fidelity’s 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% may not seem too attractive relative to current cash savings rates but will become more appealing if interest rates do continue to 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 share prices of the fund’s holdings may also rise as interest rates fall.

The one infrastructure investment trust on our list is International Public Partnerships, which yields 6.1%. The trust, which owns assets such as hospitals and care facilities, toll roads, railways and digital cabling, currently trades at a discount of 20.6% to the value of its assets. 

Currently there is just one property fund on the Select 50, the iShares Environment & Low Carbon Tilt Real Estate Index Fund. This fund is a tracker – it passively follows an index – and is open-ended. Like First Sentier Global Listed Infrastructure, it invests in the shares of quoted companies rather than directly in property. It yields 3%.

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.

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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 cut rates simply because inflation has been brought under control, it is unalloyed good news for most parts of the stock market (banks and insurers are the main exception because they tend to prosper from higher rates). In this scenario, stocks should benefit for two reasons: first, because a decline in the appeal of cash savings tends to make all other assets more attractive on a relative basis; second, because 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 must balance the positive effects of rate cuts against the damage likely to be done to corporate profitability by an economic downturn. 

If you’ve got a burning question you want to ask, why not drop us a line. Ask us your question. 

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• Read: Select 50: why we have added this fund to the list
• Watch: How will rate changes hit borrowers and savers in 2025?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. 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. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy funds. Equally, if a fund you own is not on the Select 50, we're not recommending you sell it. You must ensure that any fund you choose to invest in is suitable for your own personal circumstances. 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.