Income risk is the potential that the income paid out by a fund will drop as the result of a shift in applicable interest rates. This type of risk is greater with funds that make use of short-term investments as a means of generating revenue for the fund, and with money market accounts. In contrast, investments where a specific interest rate is locked in for an extended period of time will carry a lesser degree of income risk.
Fluctuation of interest rates can often have a significant effect on the performance of various investments held by a short-term investment fund and increase the degree of income risk for that fund. This is because the managers of the fund are continually reinvesting at the most current available rate. When the average interest rate decreases, that also causes the rate applied to those assets to drop. As a result, even a solid investment will generate less in the way of income until the interest rate begins to increase once more.
A simple example of how income risk works is to consider the income that is generated from a money market. The interest rates used to calculate the payout 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 disbursements on a rate of 3.75%. Should the current interest rate dip to 3%, then the money market will adjust accordingly, adjusting the rate used to determine income payouts to 2.75%. This approach makes it possible to always keep the disbursements below the amount of interest income generated, a factor that ensures the money market remains strong and 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.
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. By diversifying the portfolio and recognizing that interest rates will fluctuate from time to time, beneficiaries are not left short, and can look forward to periods in which interest rates are high and the payouts are more generous.