I use the word “diversification”’ a lot. I know it’s basic, even boring, but I’m a believer. For over four decades, I’ve watched clients with diversified portfolios build their wealth and achieve their goals.

But the word’s meaning is more nuanced than I sometimes let on, particularly with regard to fixed income.

When I started in the 1980s, two asset types made up the secure section of portfolios – government bonds and T-bills. Today, there’s a plethora of products with different features and use cases.

All have a fixed obligation to pay interest and repay principal, but they diverge from there. In balanced portfolios, some help smooth returns, some protect against market meltdowns, and some provide no diversification at all.

Let’s look at the fixed-income tool kit through a diversification lens.

Savings vehicles

There are many options in the short-term savings category – T-bills, GICs, money market funds, and cash management products.

These are simple to understand. The yield is clearly stated and the principal holds steady, even in bear markets. In a portfolio, they help smooth out the bumps and provide ready liquidity for spending and rebalancing.

There’s a cost, however, to holding savings products in investment accounts. The yield will generally be below your required return and may not fully offset inflation.

Government bonds

Government bonds are longer-term loans (five to 30 years). Like the savings vehicles above, there’s no risk of default. You know you’ll get your money back.

But government bonds are a more valuable offset to stocks because they’re sensitive to changes in interest rates. Remember, when market yields drop to stimulate a faltering economy or deal with a crisis, the bonds you already own become more valuable. With turbulence all around, government bond prices go up (the longer the term, the more a bond responds to rate changes).

Government bonds are the place to be at crunch time, but there are trade-offs. They provide a steady income, but again, the potential return is less than most portfolios hope to achieve. And the returns can be volatile as interest rates change. They’ll be times when you wonder why you own them. That is, until they show up to save the day.

I’ve talked so far about one source of return – interest rate risk. There’s another useful tool in the kit – credit risk, or the risk that a borrower defaults on a loan.

Investment-grade bonds

Corporate bonds have credit risk and holders are compensated with higher yields versus comparable government bonds. The extra yield is called a spread. How much spread depends on the reliability of the borrower. Investment-grade borrowers such as banks, insurers, telcos and utilities are unlikely to default and therefore have a modest spread – 0.5 to 1.5 percentage points. For bonds issued by less reliable and/or cyclical borrowers, spreads range up from three percentage points.

Spread product is a valuable part of any portfolio but it complicates the diversification picture. When the economy and markets are weak, investors worry about defaults and spreads go up, which negates some of benefit derived from falling interest rates.

High-yield bonds

Riskier “high yield” bond funds have an excellent return record, in some cases rivalling equities.

One of my rules of thumb, however, is that if something has equity-like returns, it also has equity-like risk, and most likely is highly correlated with the stock market. That’s the case here.

High yield generally has shorter terms-to-maturity, which means it benefits less from rate declines. The biggest swing factor is changing sentiment towards defaults. Growing negativity can push spreads from the mid-single-digits to the low- to mid-teens. Yes, five to 10 percentage points.

High yield is great return generator but not a great diversifier. It’s technically in the fixed-income bucket but behaves more like stocks.

Private credit

Private debt funds, which hold loans that aren’t publicly traded, have been the fastest growing asset class over the past decade. As the category matures, the differences between private debt and high-yield bonds are narrowing.

There is one big difference, however – private loans usually have floating rates. The yield goes up and down with interest rates. In a falling rate environment, holders get hit by dropping yields. If spreads are also rising, these funds, like high yield, are not dependable diversifiers.

I’ve left convertible bonds, mortgages and preferred shares for another day. In the meantime, I hope you’ll assess your fixed-income holdings with a more discerning eye. Be clear on their purpose, and ask yourself whether they’re there to enhance your returns or provide downside protection.