Do you really need bonds in your portfolio? That is a reasonable question to ask, particularly at a time when interest rates are low. Income from bonds is minimal so the incentive to hold non-equities is lower than normal.
The answer to the question is somewhat dependent on the age of the investor, but even then, bonds may not be required. For example, suppose you are receiving a $1,500 social security check each month. This monthly income is backed by what I call a “bond equivalent.” By “bond equivalent,” there is money, or a promise of some sum of money, generating that monthly income and it is backed by faith in the U.S. government. Although we don’t consider this “bond equivalent” as part of the portfolio, neither should it be neglected in your portfolio analysis.
How do we evaluate the “bond equivalent?” William Bernstein, in his excellent book, The Four Pillars of Investing, writes the following.
“…if you are one of the vanishing number of individuals lucky enough to be getting regular fixed pension, then you own, in essence, a bond issued by your former employer. If that employer was the government, you can capitalize (that is, discount) its payments by a low rate –say 6%. So, if you are relatively young, you essentially own a perpetual annuity, similar to prestite and consols. If your payments are $30,000 per year, this is the same as owning a long bond with a value of $30,000/0.06 = $500,000. If you are older, its value will be commensurately less. Your Social Security payments should be capitalized in the same way. If your pension comes from Trump Casinos, I’d capitalize it at much higher rate–say 12%–making its present value only $250,000 ($30,000/0.12 = $250,000). In any case, it would not be a bad idea to increase your stock holdings to reflect the “bonds” you effectively own via your pension and Social Security.”
Coming back to that $1,500 income from Social Security each month. That amounts to $18,000 per year and using Bernstein’s capitalization calculation of $18,000/0.06, we have a “bond equivalent” of $300,000 in the “bank.” To carry this further, I know an individual who is one of the vanishing number to have a pension that pays approximately $4,500 per month or $54,000 per year. Once more, using Bernstein’s calculation, $54,000/0.06 = $900,000. If this person also collects Social Security it makes little sense to hold bonds in a portfolio.