Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

19th century UK gilts mispricing versus modern on-the-run bond pricing

Andrew Odlyzko has an interesting paper entitled “Economically irrational pricing of 19th century British government bonds ” (available on SSRN) which demonstrates that more liquid perpetual bonds (consols) issued by the UK government often traded at prices about 1% higher than less liquid bonds with almost identical cash flows. Given that interest rates in that era were around 3%, these perpetual bonds would have a duration of well over 30 years. So the 1% pricing disparity would correspond to a yield differential of about 3 basis points. That is much less than the yield differential between long maturity on-the-run and off-the-run treasuries in the US in recent decades, let alone the differentials in the Indian gilt market.

In other words, contrary to what Odlyzko seems to imply, the 19th century UK gilt market would appear to have been more efficient than modern government bond markets! Odlyzko provides a solution to this puzzle. Most of UK consols in the 19th century were held by retail investors and very little was held by financial institutions. As Odlyzko rightly points out, this would substantially depress the premium for liquidity. Odlyzko argues that the liquidity premium should be zero because the stock of the liquid consols was more than adequate to meet any reasonable liquidity demands. I do not agree with this claim. The experience with quantitative easing since the global financial crisis tells us that the demand for safe and liquid assets can be almost insatiable. That might well have been true two centuries ago.

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