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Bonds are often classified as “low risk” or “high risk,” but this is only half of the story. There are actually two kinds of risk: interest rate risk and credit risk. These are two distinct types of risk that can have a very different impact on various asset classes within the bond market.

Interest rate risk is the vulnerability of a bond or fixed income asset class to movements in prevailing interest rates. Bonds with elevated interest rate risk tend to perform well when rates are falling, but they will underperform when interest rates are rising. (Keep in mind, bond prices and yields move in opposite directions ). As a result, rate-sensitive securities tend to perform best when the economy is slowing, since slower growth is likely to lead to falling rates .

Credit risk, on the other hand, is a bond’s sensitivity to default. or the chance that a portion of the principal and interest will not be paid to investors. Individual bonds with high credit risk will do well when their underlying financial strength is improving, but they will weaken when their finances deteriorate. Entire asset classes can also have high credit risk; these tend to do well when the economy is strengthening and underperform when it is slowing.

While some areas are more sensitive to interest rates – such as U.S. Treasuries. Treasury Inflation-Protected Securities (TIPS), mortgage-backed securities and high-quality corporate and municipal bonds – others, such as high yield bonds, emerging market debt, floating rate bonds. and lower quality munis, are more sensitive to credit risk. Understanding this difference is critical to achieving effective diversification.

Risk by Asset Class

U.S. Treasuries and TIPS. Government bonds are considered to be completely free of credit risk, since the U.S. government is still seen as being the safest borrower on the planet. As a result, Treasuries and TIPS are free from credit risk – meaning that a sharp slowdown in growth or an economic crisis won’t hurt their performance, and in fact might help.

On the other hand, both are highly sensitive to rising interest rates. When the Fed is expected to raise rates. or when inflation is a concern for investors, yields on Treasuries and TIPS will likely rise (as their prices fall). In this scenario, longer-term bonds will perform much worse than their short-term counterparts. On the other hand, signs of slowing growth, falling inflation. or the Fed’s intention to raise rates are all a positive for rate-sensitive government bonds in general, and longer-term bonds in particular.

Mortgage-Backed Securities. Mortgage-backed securities (MBS) also tend to have low credit risk, since most are backed by government agencies or sold in pools where individual defaults don’t have a significant impact on the overall security. MBS are highly sensitive to interest rates, however. The asset class can be hurt in two ways: 1) by a sharp increase in rates, which causes prices to fall, and 2) a sharp decline in rates, which prompts homeowners to refinance their mortgages, which can lead to return of principal (which needs to be reinvested at lower rates) and a lower yield than investors were anticipating (since there is no interest paid on the retired principal). MBS therefore tend to perform best when rates are stable.

Municipal Bonds. Not all municipal bonds are created alike. The asset class is home to both higher-quality, safe issuers, and lower-quality, higher-risk issuers. Bonds on the higher-quality end of the spectrum are seen as being very unlikely to default; therefore, interest rate risk is by far the largest factor in their performance. As you move toward the higher-risk end of the spectrum, credit risk becomes the primary issue and interest rate risk has less of an impact.

For instance, the financial crisis of 2008 – which brought with it fears of rising defaults for lower-quality bonds of all types – led to extremely poor performance for lower-rated, high yielding munis, with many funds that are invested in the space losing over 20% of their value. At the same time, the exchange-traded fund iShares S&P National AMT-Free Muni Bond Fund (ticker:MUB), which invests in higher-quality securities, finished the year with a positive return of 1.16%. In contrast, many lower-quality funds produced returns in the 25-30% range in the recovery that occurred in the subsequent year, far outpacing the 6.4% return of MUB.

The takeaway? The type of municipal bond or fund you choose can have a huge impact on the type of risk you’re taking on, and the returns that you can expect under varying circumstances.

Corporate Bonds. Corporate bonds present a hybrid of interest rate and credit risk. Since corporate bonds are priced on their “yield spread ” versus Treasuries – or in other words, the yield advantage they provide relative to government bonds – movements in government bond yields have a direct impact on the yields of corporate issues. At the same time, many corporations are seen has being less financially stable than the typical government, so they also carry credit risk.

Higher-rated, lower-yielding corporates tend to be more rate sensitive because 1) their yields are closer to Treasury yields and 2) they are seen as being less likely to default. Lower-rated, higher-yielding corporates tend to be less rate sensitive and more sensitive to credit risk because 1) their yields are further away from Treasury yields and 2) they are seen as being more likely to default.

High Yield Bonds. The largest concern with individual high yield bonds is credit risk. The types of companies that issue high yield bonds are either smaller, unproven corporations or larger companies that have experienced a degree of financial distress. Neither are in a particularly strong position to weather a period of slower economic growth, so high yield bonds tend to lag when investors growth less confident about the growth outlook.

On the other hand, changes in prevailing interest rates have less of an impact on high yield bonds’ performance. The reason for this is straightforward: while a bond yielding 3% is more sensitive to a change in the 10-year U.S. Treasury yield from 2% to 2.3% — meaning that the yield spread moves from 1.0 percentage points to 0.7 percentage points – the difference is less pronounced in a bond paying 9%. In this case, the spread would move much less on a percentage basis: from 7.0 percentage points to 6.7.

In this way, high yield bonds – while risky – can provide an element of diversification when paired with government bonds. Conversely, they do not provide a great deal of diversification relative to stocks.

Emerging Market Bonds. Like high yield bonds, emerging market bonds are much more sensitive to credit risk than interest rate risk. While rising rates in the United States or developing economies typically will have little impact on the emerging markets, concerns about slowing growth or other disruptions in the global economy can have a major impact on emerging debt.

The Bottom Line

In order to diversify properly, investors have to understand the risks of the types of bonds they hold. While emerging market and high yield bonds can diversify a conservative bond portfolio, they are much less effective when used to diversify away from stocks. Along the same line, rate-sensitive holdings are useful in diversifying stock market risk, but they will saddle investors with losses when rates go up.

Simply put, be sure to understand the specific risks – and performance drivers – of each market segment before constructing a bond portfolio.