How Does Income Risk Occur?

Income risk is the chance that a fund's interest rate will drop in response to the drop of national interest rates. The fund cannot continue to pay out rates far higher than it is earning, so your income could take a sudden down turn. The risk is highest in a volatile economy and with a short-term fund.

Volatile Economy

Interest rates drop when the economy is slow. The rate is lowered to encourage banks to lend more money and to curb the affects of inflation. When this occurs, though, income rates on funds will have to go down in order to stay below the current interest rate.

Short Term Funds

In general, the affect of income risk is most noticeable on a short-term, fixed-income fund. The most common example is a money market fund. The money market fund may have initially be issued at 4.5 percent when the national prime rate was 5.25 percent. You were earning a nice income off the fund. Suddenly, with a crash in the market, the national prime rate is dropped to 3 percent. As a result, the issuing institution for the money market fund has to drop the rate to 2.25 percent. You are now earning only slightly higher than you would in a savings account.

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