Income Risk Explained 2025: How Interest Rate Drops Affect Your Fund's Earnings

Charlene Rhinehart is a CPA and CFE, serving as chair of an Illinois CPA Society committee, with a background in accounting and finance from DePaul University.

What Is Income Risk in 2024?

Income risk refers to the possibility that the income generated by a fund, especially those investing in short-term debt instruments, will decline due to falling interest rates. This risk is particularly significant in money market funds and other short-term income strategies, unlike long-term investments that lock in fixed interest rates.

Key Insights

• Income risk arises when yields from funds investing in short-term debt securities decrease because of lower interest rates.
• This risk primarily affects money market funds and short-duration income funds.
• Interest rate fluctuations directly influence the performance of short-term investment funds since income is continuously reinvested at prevailing rates.

Deep Dive: Understanding Income Risk

Income risk is essentially the potential drop in yield a fund experiences when interest rates fall. Since short-term funds reinvest income frequently, a decline in rates means subsequent investments earn less, reducing overall income.

For instance, a mutual fund focused on money market securities with maturities under one year will see its returns fall if interest rates decrease. When these securities mature, reinvestment occurs at the new, lower rates, diminishing income. While similar to interest-rate risk, income risk specifically relates to funds, whereas interest-rate risk concerns individual bonds.

Typically, money market funds calculate payouts slightly below the current interest rate to maintain sustainability. For example, if the prevailing rate is 4%, income distributions might be based on 3.75%. Should rates drop to 3%, payouts adjust to around 2.75%, ensuring the fund remains solvent and capable of future income generation. However, this adjustment means beneficiaries receive reduced income until rates rebound.

Strategies to Reduce Income Risk

To mitigate income risk, investors can diversify their portfolios by balancing short-term income funds with long-term fixed-rate investments. This approach helps stabilize income streams, as fixed-rate holdings offset declines from short-term funds when interest rates fall. Consequently, investors benefit from a more predictable income floor, enabling better financial planning.

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