Issue #36: BWIC

Last week we started talking about how the markets are a continuous two-way auction process. We focused on listed, highly liquid things like index and commodity futures, but this week we are going to explore how auctions work in less liquid markets like bonds and private equity.

Most fixed income securities are traded over the counter (OTC) which means they are not traded on an exchange like the NYSE. Aside from some electronic trading and messaging platforms like Bloomberg and TradeWeb, the main way of trading bonds in the OTC market is the BWIC process. A BWIC is an auction for a collection of bonds that is sent out by the seller to the marketplace for competitive bidding at a specified time. Most bonds don’t trade very often and can easily go for weeks or months without trading. When a BWIC is sent out to the market dealers will give their guesses as to where those bonds will trade based on where similar bonds in the market have recently traded; this is called “price talk” and is like overnight trade or pre-market indications for listed securities.  Customers and dealers submit their bids to the seller based on the price talk and after a few rounds of bidding the high bidder wins the auction when they outbid everyone else, creating excess. The OTC market never opens or closes unlike exchanges that have defined trading hours; so the BWIC could be thought of as a single market session on an exchange as there is the a defined start time and the BWIC usually ends when the sellers sends out the results of the auction to the market.

This “color” from the seller is the most important information in the OTC market because unlike an exchange there is no central store of prices for bonds; in other words, the OTC market is very opaque and is like the wild west. The bigger money managers will run BWICs daily to manage their daily flows but also to collect this valuable information. There are many companies that also collect this data and resell it to market participants but each one has idiosyncrasies to their data which limits the ability for any single source to be a central source of price information. Back in the day, there were books published with bond prices that traders would use to trade bonds.

Dealers sit in the middle of BWICs: publishing price talk, collecting customer orders, and even bidding for their own position. As the buyer your goal is to not have too much excess otherwise known as “a tight cover”, so it will be easier to resell your bond later. The “winner” of a bond on a BWIC is the laggard buyer in the auction, meaning they are the last and highest bid of all the other bidders. Now you usually do not want to be the laggard buyer because when an auction ends there is a risk that the price was too high, and the next auction will correct that excess. However, the buyer in a BWIC is betting that a longer-term auction is underway (it could be days, weeks, months, or years) and that while they are a laggard in the BWIC auction, they are the innovator, early adopter, or early majority in the longer-term auction which also means that today’s high prices will end up being tomorrow’s low prices.

Last week I talked about the importance of “firm” and “customer” orders on the floor; in BWICS many times you know exactly who your competition is which is a much richer set of information than listed markets provide, so you can know if the other bidders are fast money (typically hedge funds and other short-term investors) who are just in it for a flip or real money who are usually buy and hold. Fixed income salespeople will talk about museum pieces which are real money (long-term investors) bonds that get bought and never come back out to the market. When they do show up on a bid list they tend to be highly sought after. So, while the OTC market is opaque in terms of pricing information it provides a much richer set of other market generated information that market participants can use to understand the market.

There is a focus on price in all markets but since price is easier to observe in the listed markets you see things like technical analysis being used more frequently to analyze those markets, whereas you don’t really see people using technical analysis on corporate bonds or mortgage-backed securities. I found this to be very helpful when trading bonds for the buy and sell side because it was easier to sit back and understand the market versus getting caught up in all the day-to-day machinations that happen in the listed markets. The important thing to remember about all markets that are financial in nature is that price is just one variable. It is an important variable, but it does not tell the whole story; you have to be able to also observe the volume and time that the market gives to any particular price to understand what the market is doing.

I believe that Cathie Wood is the laggard buyer today. She is brilliant and many of her theses are likely correct, however the timeframe that they are expected to play out over is very long and likely longer than her investors are willing to hold her funds. Autonomous driving? Sure, but who knows when? We see this timeframe mismatch all the time in financial markets, especially in times of extreme speculation. Cathie Wood doesn’t really care what her investors’ timeframe is, she is incented to just get more investors in her funds to grow AUM. One of the biggest mistakes all investors make is misdiagnosing their timeframe. Warren Buffet is widely regarded as one of the greatest investors of all-time, and what he did right was to match his investing style with his timeframe. Today there is a ton of excitement about all the new technologies and exponential growth, but usually you have very short-timeframe money chasing that stuff, despite the fact it will take years for the technology to be commercialized and widely adopted. We saw this in the internet bubble too. A lot of the companies that ended up going under back then built the foundation of the technology we all use today and led companies like Google and Facebook to trillion-dollar market caps (ok, not quite there for Facebook, but close enough).

Family offices and other ultra-wealthy investors are also the laggard buyers today in the venture capital and private equity markets. Thanks to David Swenson and his Yale Model, there has been such a focus on allocating more money to alternative investments that these investors are now looking to deals directly, circumventing the traditional VC and Private Equity managers. VC’s today complain about having to beg founders to take their money because there is so much money being thrown around from non-traditional investors. The market has gotten so busy that there is no time to do due diligence; if you want to win a deal you have to be able to move quickly and that does not leave time for the traditional due diligence process. This is another form of excess. We said last week that markets move from balance to excess and back to balance. These new entrants to the auction process have pushed prices and the quality of your average deal beyond what was considered normal or balanced (Over the first six months of this year, the average valuation of early-stage venture capital companies increased 50% to $93.1mm). Now, just because they are laggard buyers doesn’t mean that prices can’t keep going up. That is the thing about auctions, you only know excess after the fact, but if you focus on understanding how markets work you can see early signs of excess before others.

As we talked about last week and have alluded to in past letters, just because we are seeing signs of laggard buyers and excess today does not mean the market is about to reverse lower. This gets back to the earlier point about timeframes and is a reminder that prices do not go down just because they are high, you need to see sellers too. That is the weird thing about the equity market today: we are seeing plenty of speculation (meme stocks), laggard buying (FO’s, ARKK, Softbank, etc.), high valuations, but we are not seeing large investors meaningfully change their allocations to equities which probably has a lot to do with monetary and fiscal policy. The hard part is that you can fall into the trap that the market is crazy and has to crash just as easily as you can fall into the trap that the market is just going to go up forever because the government won’t let it go down. In the end of the day inflation is going to be the thing that tips the scale, but in the meantime spending time to think deeply about how the market works is the best way to understand what is going on today.