What Is Income Risk?
Income risk is the risk that the income stream paid by a fund will decrease in response to a drop in interest rates. This risk is most prevalent in the money market and other short-term income fund strategies (versus longer-term strategies that lock in interest rates). Income risk is an extension of the interest-rate risk on an individual bond.
Key Takeaways
- Income risk is the risk that the yield of a fund investing in short-term debt securities will decrease because of a decline in interest rates.
- This risk is most prevalent in the money market and other short-term income fund strategies.
- The fluctuation of interest rates can often have a significant effect on the performance of various investments held by a short-term investment fund; this increases the degree of income risk for that fund because the income generated by the fund is continually reinvested at the current rate.
Understanding Income Risk
Income risk is the risk that the yield of a fund investing in short-term debt securities will decrease because of a decline in interest rates. The fluctuation of interest rates can often have a significant effect on the performance of various investments held by a short-term investment fund; this increases the degree of income risk for that fund. This is because the income generated by the fund is continually reinvested at the current rate.
For example, consider a mutual fund that invests in money market securities with maturities of less than a year. If interest rates decline, then the yield on the money market fund will also decline: when the money market securities mature, the returns are reinvested at lower interest rates. Income risk is the same concept as interest-rate risk, but the income risk applies to funds, while the interest-rate risk applies to individual debt securities.
The interest rates used to calculate the payout from a money market fund are typically a little less than the prevailing rate. This means that if the current interest rate is 4%, the money market may base income disbursem*nts on a rate of 3.75%. Should the current interest rate dip to 3%, then the money market will adjust accordingly, shifting the rate used to determine income payouts to 2.75%.
This approach makes it possible to always keep the disbursem*nts below the amount of interest income generated, a factor that ensures the money market remains capable of generating more income in the future. At the same time, any beneficiaries of the fund find that their available income from the fund is reduced until interest rates increase.
Minimizing Income Risk
One strategy for minimizing the degree of income risk associated with a portfolio is to diversify the assets so that long-term investments with fixed rates of interest are balanced with short-term income fund holdings. Doing so creates a situation in which the fixed rates on the long-term investments offset any decreases in income that may occur when interest rates drop. This helps to establish a more consistent floor for income payouts, allowing beneficiaries to arrange their budgets based on that minimum.
