Pricing of Government Bonds at the Time of Issue

The introduction of an auction system for the issuance of government bonds has brought the Austrian bond market closer to international standards. However, when issue prices are compared to theoretical prices derived from the secondary market, some issues show significant "overpricing". This might be due to the low liquidity of the secondary market, barriers between the primary and the secondary markets and market participants who fail to engage in arbitrage. The attractiveness of the Austrian bond market has increased during the past years. In February 1991, significant quality improvements were achieved by introducing an auction system for the issuance of government bonds. Before that time the condition of the new issue had been decided in the Austrian Capital Markets Committee and in a meeting of the involved banks. Now these conditions are determined as the result of an auction. For most bonds there is a negative or only slightly positive difference between issue prices and theoretical prices (see Chart). But several times (February 1991, January 1993, and since September 1993) a significant degree of "overpricing" for government bond issues can be detected: the issue price significantly exceeds the theoretical ("fair") price as determined in the secondary market. This means that the auction procedure resulted in the federal government obtaining more than the price situation in the secondary market warranted. A large part of this difference between theoretical and realized issue prices is due to a lack of efficiency and liquidity of the secondary market. This seems counter-intuitive, since it is to be expected that when liquidity is increased even small price deviations should disappear quickly – if they are recognized. It seems that market participants recognize mispricing not at all or only with a time lag, or that participants do not make use of their arbitraging possibilities. It is not clear whether the simultaneous occurrence of overpricing in the fall of 1993 has something to do with an increasing share of foreigners buying Austrian bonds at that time: when overpricing occurred previously, the share of foreigners buying Austrian shares was very low (6 percent in February 1991 and 4.7 percent in January 1993). Similarly when in December 1993 the highest degree of overpricing occurred, the share of foreigners (11.4 percent) was also significantly below that of previous months. The real problem seems to be (and this is corroborated by the fact that foreigners purchase new issues) that it is nearly impossible to carry out large volumes of transactions (in international terms) into the secondary market at "stable" prices. Such investments have a reasonable chance only for new issues. The pressure to invest causes price distortions resulting from investment competition among the participants in the auction. The federal government and the banks should both have an interest in having bond issues conform to market conditions. This will only be possible if the secondary market becomes more efficient by means of more liquidity and a more professional behavior on the part of market participants.