What are you expecting from the bond portion of your portfolio over the next five years? 5%? 6%? 7%?

These would all have been reasonable expectations in the past, but past is not prologue, especially when it comes to investing.

Whatever number you were thinking of, it is likely too high. Why?

• The largest Bond ETF (AGG), with over $41 billion in assets, has a current yield of 2.13%.
• The second largest Bond ETF (BND), with over $31 billion in assets, has a current yield of 2.41%.

What does this have to do with returns? As it turns out: everything.

In the bond market, the beginning yield has been the single best predictor of forward bond returns. The lower the starting yield, the lower the future return. The higher the starting yield, the higher the future return. The linear relationship is clear.

Five years ago, the yield on the Barclays Aggregate Bond Index was 2.24%. What have bonds done since? The two largest bond ETFs (BND and AGG) have returned 10.04% and 10.28% cumulatively, or 1.93% and 1.98% annualized. As predicted by their low beginning yields, these are among the lowest 5-year returns in history (annualized return for the Barclays Aggregate since 1976 is 7.5%).

The Elephant in the Room

As much as we would like to, we can’t change bond math. What we can do is start talking about this elephant in the room and what, if anything, to do about it. Low single-digit bond fund returns are not something most investors, both retail and institutional, are prepared for.

But what can an investor do? There are three main options:

(1) Take more risk with an increased weighting to higher yielding bonds in the U.S. or emerging markets.

(2) Take more risk with a higher weighting to equities.

(3) Save more, spend less, retire later.

The first and second options require changing ones risk tolerance which is neither easy nor advisable for most investors, particularly those nearing retirement. They also assume that returns will be sufficiently higher in those other asset classes to compensate you for the additional risk, which may not be the case given the lower yields in junk debt and higher valuations in U.S. equities.

Which leaves us with the most unpalatable but also the most realistic option: expecting lower returns in the years to come and adjusting your lifestyle accordingly. Save more, spend less, retire later (I know, who wants to hear that?).

And hope for higher interest rates as that will be the only long-term cure for low bond returns.