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Looking at UK government bond prices and picking out one example of what I mean:

                     Coupon Maturity    Trading price
Treasury 8% 2021     8      07-Jun-21   123.08
Treasury 4,3/4% 2020 4.75   07-Mar-20   108.11

Why is the disparity between these two not arbitraged away? Despite the higher price, yield for the first one is substantially better, and (at least compared to 30 year options) the maturity date is similar, so why would anyone continue to hold the other one when they could trade for the first?

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The disparity is not as significant as you are presuming. A bond's current price and yield can be deceiving if not considered with respect to the bond's maturity.

What you're overlooking is that when a bond matures, you get back the face redemption value of the bond — not the price you originally paid for the bond. And the market price you originally pay for a bond can be higher or lower than the maturity value, depending on prevailing interest rates vs. when the bond was issued.

If these bonds lasted forever, then comparing current yield would be more meaningful. (And if they lasted forever, they'd be called "consols".)

But with these bonds each maturing within a handful of years, and the face redemption value of the bonds being less than their current market prices, what one has to look forward to at maturity is a capital loss on the value of the bond. I'm presuming that what your £123.08 or £108.11 gets at maturity is an even £100.00 redemption value back. (Where I come from, bonds are typically issued with face values of $1000, but are quoted on the basis of $100, i.e. divided by 10.)

Your overall return of a bond purchased and held to maturity will be a combination of the coupon payment interest, plus either a capital gain if the bond was purchased below redemption value, or less a capital loss if the bond is purchased above redemption value.

Back to your example. If you click into each bond's details, you'll see that the first (maturing in 2021) is presently showing a Redemption Yield of 0.8490% while the second (maturing in 2020) is presently showing 0.7050%. These rates factor in the difference in current price and redemption value.

The better comparison of these bonds looks at their yields-to-maturity and time to maturity. So, in that context, the bond with the extra year of maturity having a slightly higher yield-to-maturity is expected. Refer to Wikipedia - Yield curve - Normal yield curve. But I wouldn't call out the difference as a large disparity — it certainly isn't a disparity as proportionately large as between prices of £123.08 and 108.11 or running yields 6.5% and 4.4%.

  • +1 tbf the disparity is much larger than it was a few years ago before the risk premium rose. – MD-Tech Mar 1 '18 at 15:08
  • @MD-Tech The disparity being referred to in the question is between the price of the two bonds today, not the bonds today and what they were worth years ago. I do expect their value has changed significantly over time and owing to political events. I'm showing that their YTMs of 0.8490% and 0.7050% are quite a bit closer than their prices and yields alone would lead you to believe. – Chris W. Rea Mar 1 '18 at 15:11
  • There is an event possibly occurring at about the time of the two bond maturities that means that the one maturing definitely after the event is more risky than the one before it. Noting that the event will take some time to crystalize – MD-Tech Mar 1 '18 at 15:14
  • @MD-Tech Yes, higher perceived risk generally means the instrument should be priced so the return is higher. But even in general (i.e. these specific political events and risks aside), longer term bonds typically have higher YTM than shorter term bonds simply because the money is locked in longer, which gives risks, in general, more time to materialize. (Though there are times when the yield curve is inverted, not usually a good sign for the economy.) – Chris W. Rea Mar 1 '18 at 15:23
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    Got it. So we're looking at differences in yield to maturity of (annualized) 0.7% vs 0.6% - no great difference. – Sideshow Bob Mar 1 '18 at 16:55
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The shape of the yield curve; the curve that relates maturity date to yield, has changed in recent months meaning that the curve has un-inverted and returned to a state where future risk is priced more normally. This means that longer maturities have a higher yield as there is more risk of adverse affects happening in the distant than the near future. 1 year extra is quite a bit more distant with higher political risk.

Thanks to political and economic risk increasing for the UK, the risk premium has increased as international (i.e. non-UK) bond holders have sold off their holdings.

There is more risk as you go further into the future (both on the up and down sides — i.e. higher standard deviation/larger error bars) so this increased risk has a bigger effect further into the future, so the size of the risk premium is higher, and therefore the required yield is higher.

It bears repeating that it is only the size of the risk (c.f. uncertainty) and not the direction of the risk that is important. If you believe that the increased risk premium is unjustified it may be the time to buy.

  • Under the assumption made by the OP that the bonds differ significantly in yield, this is not the right answer. – jwg Mar 1 '18 at 18:08

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