Creating the Consols

For over a century, perhaps the most significant security in the world was the British consol. One consol was just like any other; for most of their history, they paid 3% interest perpetually. Yet, fifty years before their creation, government borrowing in Britain made use of a broad array of different instruments. Nevertheless, history ultimately settled on the ‘Three Per Cent Consols’. The consols had their origin in a mid-18th century plan to reduce the government’s borrowing costs by renegotiation with investors.

Wars and Annuities

Ever larger public debts and military engagements were entangled realities in 18th century Europe. Perhaps nowhere was this truer than in Britain, which developed an expensive navy during a period of global competition with France, a navy that required large capital expenditures financed out over time. During the late 17th and early 18th centuries, the country fought frequent wars against the French king, Louis XIV.

Funding a war invariably meant borrowing money and loans were usually harder to come by in times of war when yields on government debt rose as investors were fearful. Sometimes, a government might issue short-term debt during the war only to refinance this into longer-term debt after peace made market conditions more favorable. Regardless, lower borrowing costs and an ability to borrow larger sums could provide one country or the other with an advantage.

In 1542, the Habsburg Emperor Charles V placed certain wartime demand on his Dutch provinces. The provinces solved for this need for funds by the issuance of life annuities, which offered buyers equal payments over the course of one or two lifespans, and heritable annuities, which were perpetual. Either route entailed investors paying a lump sum to the state in exchange for a series of future payments. Annuities remained common means of financing state debts for more than three centuries.

In England, the first perpetual annuities were introduced during the reign of William III. While somewhat of a simplification, Britain and France took different routes with respect to annuities from then on. Whereas France offered many life-annuities as a means of financing government spending, Britain sold perpetual annuities to its creditors.

Borrowing Costs

Long-term borrowing cost the British government 8% per year in interest in 1710 but this fell to as low as 3% in the mid-1730s. Much of this borrowing was done by issuing perpetual annuities that paid a fixed interest rate with no maturity. The first 3% annuities, called the “Three Per Cent Bank Annuity”, were issued in 1726 with the assistance of the Bank of England in order to repay more expensive government borrowings then outstanding. Annuities at 3% and 4% were the favored instruments for raising public loans.

Since borrowing costs were coming down in the early-to-mid 18th century, there were opportunities to replace higher cost debt with cheaper borrowings. However, in practice, interest costs were reduced by renegotiation, rather than by refinancing that debt. The bonds were redeemable by the government at any time and so the state would simply offer bondholders a choice between a lower rate of interest or redemption.

The hope was that investors would choose the lower rate rather than redemption. This strategy provided a way to lower borrowing costs without the expense of issuing new securities which would often just go to the same holders as the existing securities anyway. If the government achieved its goal and only a small number of bondholders elected the redemption, the state would simply raise only a small loan to repay them.

Because the 4% annuities were prepayable at any time by the government, the premium that investor paid for 4% annuities versus 3% annuities was less than one might expect. The premium paid by investors for a 4% annuity corresponded to the expected 4% annuity payments in excess of those already earned by the 3% annuities. This was not simply 1% per year perpetually because the valuation must be adjusted for how long the annuities were expected to remain outstanding until the government redeemed them.

So, if investors believed the 4% annuities might be repaid imminently, this premium would be miniscule, despite the 4% annuity earning payments one-third larger. Conversely, if investors believed that a redemption would not come for some time, then the excess value of the 4% annuities over the 3% annuities was higher.

Of course, the government was more likely to prepay when market interest rates were low, that is, when prices for the 3% annuities were highest, since it was then that a government could most easily raise a loan to repay existing investors rejecting an interest-rate reduction. So, the premium paid for a 4% annuity would be lowest when prices on the 3% bonds were the highest, causing the prices of these otherwise similar perpetual government securities to diverge at times, sometimes sharply.

First Consolidation Attempt

After their 1726 debut, more 3% annuities were issued in 1727 and 1731 but much of the national debt was still financed by annuities earning 4%. John Barnard, a Member of Parliament, proposed a reduction in the interest rate by renegotiation in 1737. That year, 4% annuities were trading at 112% of face value and the 3% annuities were at 106% of face value. Barnard wanted to essentially consolidate the 4% annuities with the 3% annuities.

If an investor in the 4% annuities accepted a conversion to 3%, their investments would have depreciated by 6% of face value, the difference between the market prices of 112 and 106. If they opted against the conversion, they would have been repaid at the face value of 100 versus receiving 112, the bonds’ prior market price.

Barnard also proposed providing investors with the option to convert their perpetual annuities into fixed-term annuities or life annuities, but this was aimed mostly to appease the interests of the ‘widows and orphans’ relying on the income generated by the annuities. In any case, these options were not designed to be appealing for the typical large bondholders, which included the South Sea Company, the East India Company, and the Bank of England. The plan never received the necessary acceptance in Parliament and Barnard’s plan failed by a vote of 134 to 249.

Second Consolidation Attempt

The War of Australian Succession, from 1740 to 1748, put on hold any new attempt to consolidate the 4% annuities into the 3% securities. The government borrowed heavily with successive sets of every-larger loans, increasing the cost of borrowing as interest rates rose. Two-thirds of the annuities sold during the war were 4% annuities, which also comprised 85% of the pre-war debt. The price of 3% annuities fell but recovered with the end of the fighting; falling interest rates after the Treaty of Aix-la-Chapelle would present another opportunity for converting the 4% debt.

In 1749, the national debt comprised £12 million in 3% annuities and £58 million in 4% annuities. That year, Henry Pelham proposed a consolidation whereby the 4% annuity holders would receive their 4% interest payment for one more year in 1750 and then 3.5% for the next six years, before converging with the 3% annuities. The phased convergence to 3%, not a feature of the earlier Barnard plan, amounted to a premium of £4 paid to investors, the sum of the interest payments in excess of the eventual 3% per £100. This was roughly equal to the difference between the market prices of the 4% and 3% annuities at the time.

Henry Pelham, Prime Minster 1743-1754 (Portrait by John Shackleton)

Whether by coincidence or by plan, the premium offered in the conversion corresponded to the difference in the annuities’ market prices, which reflected investor expectations of the likelihood of a conversion. Thus, Pelham’s plan matched market expectations and the lack of any surprise made conversion more palatable.

In any case, under this approach, holders of the 4% annuities would suffer no loss not already priced into their securities’ market value, since they were essentially compensated for the fall in the value of their annuities upon the change in the interest rate from 4% to 3%. By May 1750, the vast majority of bondholders opted for conversion, leaving only £7 million worth of 4% annuities to be paid off at face value. A new loan was raised for this purpose.

Consols

Whereas in 1749, the British public debt was comprised mainly of 4% bonds, by the end of 1750, the long-term debt was comprised exclusively of 3% bonds. The government succeeded in cutting the debt service costs of the largest part of its debt by 25%. In 1751, Pelham achieved yet another consolidation.

That year, the different issuances of 3% annuities were consolidated into the “Three Per Cent Consol” with the Consolidating Act of 1751. The annuities have since been known simply as the ‘consols’. These were liquid securities with an easily referenced and readily available market price, increasing their popularity. By contrast, the life annuities relied on by the French government did not have this quality.

The Three Per Cent Consols would be the workhorse of British public finance in the 18th and 19th centuries. Whereas in the days of Pelham, the public debt stood at £76 million, it would rise to £133 million upon the end of the Seven Years’ War, £245 million after the American Revolution, and nearly £750 million after the Napoleonic Wars. Indeed, relative to GDP, British government debt was larger in 1819 than at the end of the Second World War.

Attempts to reduce the interest rate below 3% would not succeed because from the time of this consolidation to the 1840s, the consols would trade below par value. The yield demanded by investors on any new bonds was above 3%, not below. The best the government could seem to achieve, the Three Per Cent Consols, would trade in the debt markets until the late 19th century.

Lesson

Rarely does a single security maintain its importance for as long as the Three Per Cent Consols had. The vastness of their market and their uniformity likely helped. If so, then the 18th century consolidation of the British public debt was vital to their success. This consolidation was a financial maneuver perhaps only outdone in its sophistication by its scale. Nonetheless, a successful consolidation required not just that interest rates be favorable but also that a sensible offer was made, a calculation that involved closely following the markets and either altering or conforming to their expectations.

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