March 5, 2020 - There’s been major momentum on risk-free rate (“RFR”) tools in the last few weeks. On March 2nd, the Fed began publishing its long-awaited SOFR Index and Compound Averages. And in late February, the Bank of England announced that it too would publish a SONIA Index and Compound Averages. While on a standalone basis these tools are somewhat helpful for the loan market, if all jurisdictions adopt them, then they potentially could (emphasis on “could”) be quite helpful for RFR implementation in the loan market. We explain the tools and the potential uses below.
While the Fed has long published “indicative” Compound Averages of SOFR, the official rates are available here. As we’ve discussed previously, while helpful, the Compound Averages are most useful in two situations. First, they could be used to calculate interest for contracts using “SOFR Compounded in Advance”, the rate that is calculated by looking over the past 90 days to lock in the rate for the next 90 days, or for contracts where interest is not known until the end of the interest period. (The syndicated loan market declined to adopt these approaches.) It also could be used for checking the interest rate on a contract where there’s been no prepayment of principal (which cannot be guaranteed for loans). Thus, the Compound Averages are not a perfect fit for syndicated loans.
The SOFR Index is more flexible than the Compound SOFR averages. By taking a ratio of the SOFR Index value for any End Date and Start Date of an interest period, it is possible to calculate the interest rate. This is the specific ratio calculation:
(SOFR Indexend/SOFR Indexstart – 1)
(360/calendar days from start to end)
For instance, let’s say that a borrower drew down on a loan on June 4, 2018 and repaid it June 18, 2018. So a wacky 12 business day/15 calendar day loan. By clicking here, one can see the historical indicative Index levels of 1.00304643 for June 4th and 1.00378949 for July 18th. Applying the equation [(1.00378949/1.00304643-1)x360/15], one sees that the Compounded SOFR Interest rate for that period is 1.78%. Easy-peasy.
In addition, the SOFR Index embeds all the holidays and daycount weights, so that process can be simplified. But there are some buts. Like the Compound Averages, the Index works best when there’s no prepayment of principal. Once there’s a prepayment, the interest periods need to be split up into prepayment and post-payment periods and multiple calculations need to occur. The simple tool becomes somewhat less simple.
The SOFR Index can do another nice thing – but one that works best if all jurisdictions use an RFR Index. Specifically, market participants could run the calculation every day of the interest period relative to the previous day (eg, [(Day2/Day1-1)*360/1], (Day3/Day2-1)*360/1] and so on) to calculate the accrued interest for the previous day. This is simpler than building compounding capability into all loan systems. But it made no sense to build US$ compounding on an Index if other jurisdictions did not have Indices and would require internal compounding calculations. If – and it’s a big if – all other jurisdictions adopt RFR Indices, the global compounding process might (might!) be simplified. And this is why the BoE SONIA Index Consultation may be a big first step. In its consultation, the BOE specifically notes that in order to maintain global consistency, the methodology on its proposed SONIA Index is consistent with the SOFR Index. If all jurisdictions ultimately adopted official, methodologically consistent RFR Indexes, Compounded RFRs may be easier – but not easy! – to implement for appropriate loan products.