3 Key Sectors Likely to Gain from Falling Interest Rates: Banks, Utilities and REITs
Oct. 15, 2024
The Bank of Canada (BoC) have now cut interest rates twice this year with markets quickly pricing in cuts for the remaining rate-decision meetings of 2024. That would bring the overnight rate to 3.75% from its current rate of 4.5%, with potentially faster cuts to come next year — many now believe we may see the BoC’s overnight rate fall as low as 2.25% by the end of 2025.
In the U.S., due to higher-than-expected unemployment rates, many believe the delay in cutting rates in July may have been a mistake, with market expectations now leaning toward an oversized cut of 50 basis points (bps) for September with further cuts to come through the end of 2024. At one point interest rate futures suggested the Federal Reserve would cut rates by over two full percentage points by the end of 2025.
In a declining interest rate environment, certain sectors may be poised to shine more than others. Furthermore, yields across the curve have fallen substantially over the last month due to market expectations of future rate cuts. Could this leave investors looking for other yield options? Below, we highlight three sectors likely to benefit from a declining interest rate environment.
ETFs in Focus
- BMO Equal Weight Banks Index ETF (Ticker: ZEB)
- BMO Covered Call Canadian Banks ETF (Ticker: ZWB)
- BMO Equal Weight Utilities Index ETF (Ticker: ZUT)
- BMO Covered Call Utilities ETF (Ticker: ZWU)
- BMO Equal Weight REITs Index ETF (Ticker: ZRE)
- BMO Global REIT Fund Active ETF Series (Ticker: BGRT)
Banks
When interest rates drop, it typically eases the pressure on defaults along with encouraging businesses and consumers to borrow more, which represent potential tailwinds for Canada’s Big Six lenders (Royal Bank of Canada, TD Bank, Bank of Montreal, CIBC, Bank of Nova Scotia and National Bank). With additional rates cuts expected from the BoC, now could serve as a tactical time to add or increase a weighting to Canadian banks.
- With the wide dispersions between the banks as of late, one may have the opinion that not all banks are considered equal. BMO’s Equal Weight strategy is designed to remove concentration risk in a particular company. BMO Equal Weight Banks Index ETF (Ticker: ZEB) provides equal-weight exposure to large, diversified Canadian bank stocks. ZEB has a distribution yield of 4.38%1
- BMO Covered Call Canadian Banks ETF (Ticker: ZWB) call option writing reduces volatility while producing enhanced monthly cash distributions. ZWB has a distribution yield of 7.08%1
Utilities
Government bond yields tend to have an inverse relationship with Utilities (when interest rates drop, utility stock prices typically increase, and vice versa). This is mainly due to the costs involved with sector companies. The cost of construction for power plants, and the maintenance of infrastructure required to deliver gas, water, or electricity can make Utilities expensive when the cost of borrowing is high.
When interest rates decline, bond yields lower, yet demand for income remains. Utilities act as a defensive sector that can consistently pay high dividends. In a downward rate cycle, investors tend to shift away from bonds and into Utilities equities, putting demand and upward price pressure on the sector.
- BMO Equal Weight Utilities Index ETF (Ticker: ZUT) provides equal-weight exposure to large, diversified utilities stocks, and pays an attractive distribution yield of 4.27%.1
- BMO Covered Call Utilities ETF (Ticker: ZWU) pays a distribution yield of 7.75%1 and when reinvested into the portfolio can provide more cushion in downward markets. Call option writing can generate cashflow and reduce volatility.
REITs
Real Estate Income Trusts (REITs) tend to deliver strong returns during early stages of a real estate recovery cycle, which tends to align with a lower, and falling, interest rate environment. In addition, similar to Utilities, lower rates should benefit capital-intensive publicly traded companies like REITs. Lower interest rates mean lower debt payments for property buyers and lower debt payments in turn improve the economics of property deals. Therefore, real estate companies tend to increase their investing activity and expand their portfolios. The potential expansion in inventory to lease out to customers could result in potential profit growth.
- BMO Equal Weight REITs Index ETF (Ticker: ZRE) provides an equal-weight exposure to large REITs and distribution yield of 4.85%.1 Yields for REITs may look more favourable than yields on fixed-income and money market solutions.
- BMO Global REIT Fund Active ETF Series (Ticker: BGRT) is an active REIT ETF that uses a fundamental top-down, bottom-up process to select high-quality REITs. BGRT has a distribution yield of 3.78%.1
In a declining interest rate environment, Canadian banks, Utilities and REITs are likely poised to be beneficiaries of investor demand for yield. With market expectations pricing in further cuts to come in Canada, now may prove to be an attractive time to gain or add to an exposure to these rate-sensitive sectors.
Performance
Fund Name |
Ticker |
Year-to |
3- |
1- |
3- |
5- |
10- |
Since Inception |
9.76% |
5.59% |
17.85% |
3.66% |
8.14% |
6.68% |
8.13% |
||
11.79% |
7.22% |
23.94% |
6.41% |
11.55% |
8.78% |
10.55% |
||
11.06% |
6.32% |
14.10% |
1.96% |
3.16% |
3.28% |
4.51% |
||
9.78% |
14.31% |
12.89% |
-1.59% |
2.92% |
6.14% |
8.14% |
||
6.94% |
5.04% |
4.33% |
-2.42% |
6.46% |
7.14% |
6.92% |
||
10.51% |
12.58% |
17.14% |
– |
– |
– |
17.12% |
Source: Bloomberg, as of September 30, 2024.
1 Bloomberg, September 30, 2024. Annualized distribution yield is calculated by taking the most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. The yield calculation does not include reinvested distributions.
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