Adjusting interest rates for inflation to find real yields is vital to understanding bond markets. But what about taxation adjustments? If an investor during the 1951-1965 and 1990-2008 eras of “normal” inflation rates bought a ten year Treasury bond they might typically get a 5% yield when the CPI was 2.5% and they paid 35% to federal taxes, leaving them with a 0.75% after-tax and after-inflation yield. Today they might find a 3.06% 10 year Treasury yield, less 22% tax, provides 2.39% after-tax and if they subtract CPI of 2.1% then they make about 0.29% net yield.  The housing component of CPI is wrongly constructed and probably will go down when a surplus of newly constructed real estate is fully released to the marketplace, thus eventually making CPI roughly 1.5%. If that happens then a 3.06% Treasury (yielding 2.39% after-tax) would have a real-after-inflation-after-tax yield of 0.89%, slightly better than the “normal” era figure of 0.75% real after-tax return. (Tax rates are much lower today than in the pre-1986 era.)
What if an investor holds assets in a pension fund that is exempt from taxation? Then when the pension pays a monthly benefit check, then at that time it becomes taxable. A rational investor would anticipate the future tax, and if close to retirement age, might decide that the future tax shouldn’t be deeply discounted for “Present Value” but should instead be see as a contemporaneous expense not to be discounted. Some investors have control over their retirement assets and may realize that even though its tax-deferred today that eventually the yield will become a taxable withdrawal. Thus one should not assume that investors are indifferent to taxation.
I believe that taxable investors are the marginal decision makers in the bond market. The tax-exempt government agencies that buy Treasuries may be mandated buyers who lack freedom to refuse to buy. It is the taxable private sector investor, including future retirees who feel close to retirement, that are most sensitive to tax analysis, so they are the bond market movers.
The true purpose of owning bonds is simply to have a safe storehouse of value like a bank account. If the yield is low, that is unpleasant, but it is not as important as the need to have funds in safe assets. A careful analysis shows that interest rates, after considering inflation and taxes, are not that significantly different from the “normal” eras of 1951-1965 and 1990-2008. As for the high inflation era of 1966-79, real after-tax rates were sometimes negative 1.5% because if nominal rates were 10%, tax took 35%, inflation was 8% then the yield was negative 1.5%. In the Volcker Fed’s high real rates era of 1980-1986 (which continued for several years until the recession of 1990), the after-tax real rate was over 1%. Example: a nominal yield of 8%, tax at 35%, leaves the investor with 5.2%, less 4% inflation, for a net yield of 1.2% The Volcker era was a statistical outlier since it was an emergency period when rates were made by the Fed to be high so as to destroy inflation.
Investors need to focus on the optionality of holding cash and how that can be a wonderful experience during a time when a stock crash makes FANGs type of stocks drop 80% as the Nasdaq did in the 2001-2002 crash, or the 1975 NiftyFifty crash of 80% (actually a 90% decline counting inflation), or the Nikkei 75% decline which occurred in 1990.
Bonds are not the same as cash because they have duration risk; if interest rates rise that makes bond prices drop. But if a recession comes then interest rates will go down, unless there is stagflation. Given the risk that FANGs type of stocks could drop 75%, it seems well worth it to hold bonds even when yields are nominally low. To limit risk of duration one should limit their bond portfolio duration to 4 or 5; (a ten year Treasury has a duration of 9).
Investors need independent financial advice about the risks of misunderstanding bonds. If one assumes stocks are too high and due for a crash then the alternative to owning bonds would be to own stocks covered by put options but those can become very expensive or else an investor would need to be owning puts that are very “out of the money” where the investor wouldn’t be fully insured.