GKP, Bonds and Pricing

Gulf Keystone has recently released bonds at 13% with a 3 year maturity…A great deal has been written about the rate of the bonds and that they are “junk” status…..A few have even used this “junk” status as a reason to value the company and to judge the company’s credit worthiness.  This is a mistake. The valuation of bonds is based on far more than just the credit worthiness of the company.

But first let’s just dismiss this usage of “junk”, it’s a very antiquated term, which was originally used to define bonds from companies that were close to or had defaulted on the bonds. Essentially a company issuing bonds with a rating of BBB has bonds called “junk”, This applies to many household names and a large percentage of the FTSE INDEX companies. Where the bonds are BBB or higher they are investment grade…

Financials and funds are normally very limited in what they can and can’t buy and many won’t buy shares or bonds where the company is rated BBB or lower.

Most bonds issued are “junk”, the term junk isn’t really used anymore and the more accurate term of high-yield is the preferred term. GKP has only just joined the main index and I can’t find any company in the last 10 years that has moved from AIM to the main index and NOT been categorised as “junk” for its bonds. To expect GKP’s bonds to be valued at anything other than “junk” is frankly absurd.

The next mistake made seems to be referring to the reputation or credit worthiness of GKP based on the interest rate its paying on the bonds.

The rate on the bonds is made up from a large variety of components. Firstly we do have the Credit rating. However this isn’t a simply rating (as those that work in credit risk will know), its actually a multitude of information including Loss Given a Default, Default Frequencies i.e the chance of a default after 1 year, 2 years, 3 years etc. All of this information builds up a risk picture and profile for the financial instrument.  Associated with the CDF is the length of the bond.  A good example of this is that if you lend money to Greece for 1 year the risk in considerably less than for 5 or 10 years..

Other major components that affect the rate are country risk profiles, industry profiles and speed of issue. So not being able to issue investment grade debt might reduce the number of buyers by 70%, Geographic location might well reduce it by 20% (simply as some funds will focus only on certain countries and Iraq probably isn’t one of them ! ). The industry type will also reduce this further by maybe another 15%. Add on other factors and the pool of potential buyers will be less than 1% of all the buyers….As we all know if you reduce demand for a bond the rate will go up. Add in that GKP, through bad management wanted the money very very quickly and you can see why they had to pay 13%.

Does this 13% reflect the credit worthiness of GKP  ? no it reflects all of the above as well. Did the management cock up ? YEP. Is the term “junk” relevant ? No. Can you make a judgement on the value of the assets of GKP based on the interest rate ? No. You can only make a judgement that the BOD should never have allowed the company to have gone below 6 months working capital.