April 23, 2019 - On April 22^nd, the Alternative Reference Rates Committee (ARRC) released “A User’s Guide to SOFR”, which discusses the likely end of LIBOR, what it means for cash products, and how cash product consumers (such as syndicated lenders or borrowers) might think about the different variants of SOFR. We read the User’s Guide with interest and offer our key takeaways below.

Background

• LIBOR, a reference rate for more than $300 trillion contracts globally and nearly $200 trillion U.S. dollar contracts, likely will end after 2021.
• The likely replacement rate in the U.S. is SOFR, the Secured Overnight Financing Rate.

Forward Looking Term SOFR

• Unlike LIBOR, SOFR is a secured overnight rate, not a forward looking term rate. However, some market constituents (like syndicated loan lenders/borrowers) may prefer having a forward looking term rate.
• A forward looking term SOFR may be constructed based on SOFR derivatives markets once those markets have developed enough liquidity. (The development of a benchmark term rate cannot be guaranteed, and therefore, market participants that can use overnight or compounded SOFR may prefer to transition to those rates.)
• Forward looking term SOFR rates are simply segments of an overnight SOFR-OIS curve that includes a fixed and floating leg. The floating leg is the compound average of the overnight rate compounded over the interest period, while the fixed leg is set at the start of the period. The fixed and floating leg must be economically equivalent at the beginning of the period. The forward rate is simply the fixed leg of the swap. In effect, the term rate reflects market expectation as to what will happen to interest rates, while the compound average reflects what actually happens to interest rates over the period.

Average SOFR, Simple Daily SOFR and Compounded SOFR

• Many financial contracts have used overnight rates, but typically use an averageof the overnight rate, not a single day’s reading. This is because i) an average overnight rate will accurately reflect changes in interest rates in a time period and ii) average rates smooth out daily fluctuations in overnight rates.
• Average overnight rates can be calculated on either a simple interest basis or a compound interest basis.

• Simple interest is calculated by applying the daily rate to the principal borrowed, and the payment due at the end is the sum of those amounts.
• Compound interest keeps track of the accumulated interest owed but not yet paid. The interest owed each day is calculated by applying the daily rate to both the principal borrowed and the accrued, unpaid interest.
• Simple interest may be computationally easier; compound interest is the more economically correct convention and will allow for more accurate hedging.
• Compounded SOFR could either be compounded In Advance (e.g., calculated based on the prior equivalent period and thus known in advance of the interest period) or In Arrears (e.g., calculated during the course of the interest period and thus not known in advance).

Conventions for Simple Daily and Compounded SOFR

• Because interest accrues over the interest period, parties using Simple Daily SOFR in Arrears or SOFR Compounded in Arrears will not know the final interest amount due until the end of the interest period. In order to provide the counterparties sufficient time to pay interest at the end of the period, several potential conventions are feasible (and are illustrated on p. 12 of “A User’s Guide to SOFR”):

• Payment delay – The averaged SOFR is paid X days after the end of the interest period.
• Lookback – For every day in the current interest period, the SOFR from X days earlier is used.
• Lockout – The averaged SOFR over a current interest period “locks” the last few days’ rates at a rate fixed X days before the period ends.

• SOFR Compounded in Advance is known in advance, so lookbacks and lockouts are not necessary. However, parties may prefer to use different periods of time to determine SOFR Compounded in Advance:

• Last Reset – Use the averaged SOFR for the equivalent time period as the upcoming interest period (i.e., average of last 90 days for a 90-day SOFR contract).
• Last Recent – Use the averaged SOFR for a shorter time period than the upcoming interest period (i.e., average of last 30 days for a 90-day SOFR contract).

• Additional conventions will need to be developed around either Simple or Compound SOFR, including day count conventions and how the rate should be applied over weekends and holidays.

Need more information? The LSTA is a member of the ARRC, co-chairs the ARRC’s BLWG and the BLWG’s Operations Sub-Group. For more information, contact mcoffey@lsta.org, tvirmani@lsta.org or ehefferan@lsta.org.