September 10, 2020 - We have bad news, good news and somewhat complicated news. The bad news: SOFR loans can be more technically challenging than LIBOR loans, particularly if “Daily Compounded SOFR” is used. The good news: There are an increasing number of resources to tackle the challenges. In July the ARRC published SOFR Conventions for Syndicated Loans. While conventions are critical, it’s also important to understand how to actually implement these conventions. And this leads to the somewhat complicated news: In August, the ARRC published “Technical Appendices” for SOFR Loan Conventions. So buckle up, we’re about to get technical.
Calculating SOFR: Daily Simple SOFR and Daily Compounded SOFR are pulled and calculated daily, or “in arrears”, during the interest period. Operationally, this process is very different from LIBOR (or Forward Looking Term SOFR), where the rates are known in advance of the interest period. While the ARRC Conventions cover both compounded and simple rates, the ARRC Hardwired Fallbacks for Business Loans recommend Daily Simple SOFR as the second step of the waterfall (after Forward Looking Term SOFR). This is because Simple SOFR is much simpler to implement and the economics are very similar to Daily Compounded SOFR – as is demonstrated in the first two charts of Appendix 1: Simple vs Compound Interest.
Compound Fractures: For months, we have been saying that compounding interest on a prepayable loan that trades without accrued interest is…complicated. “Appendix 3: Calculating Compound Interest” walks users through the formulas and links to spreadsheets demonstrating the different approaches. There are two main ways of compounding interest: Compounding the Balance and Compounding the Rate. Compounding the Balance multiplies SOFR by the balance (principal + accrued interest) on any given day to calculate that day’s interest accrual; it permits the prepayment of loans without the repayment of accrued interest on the loan amount prepaid. Compound the Rate compounds SOFR daily and can be implemented in two ways: the Cumulative Compounded Rate and the Non-Cumulative Compounded Rate (the latter operationalizes a bit more like a daily simple interest rate). In both of these cases, any prepayments should be accompanied by the repayment of interest on the repaid amount. While the technical appendix provides the formulas, the ARRC-BLWG Compounding Methods Examples provide sample calculations to help users understand the mechanics, complexities and constraints of each approach. These examples include Simple Interest, Compound the Balance, Cumulative Compounded Rate and Non-Cumulative Compounded Rate and demonstrate a principal paydown i) with interest repayment (which works in all cases) and ii) without interest repayment (which works for the Simple and Compound the Balance methodologies).
Conventions for Timely Payment Notices: While calculating interest is the biggest conventional change in moving from a “known in advance” rate (like LIBOR) to a daily “in arrears” rate, there are other conventions that must change as well. Chief among these is a mechanism that gives the borrower enough time to receive notices and pay the interest that is due on a loan. This is an issue for “daily” SOFR because the full period’s interest rate is not known until end of the interest period – and it is hardly fair to both bill the borrower and expect them to pay on the last day of the interest period. But, as discussed in “Appendix 2: Lookbacks and Other Conventions for Timely Payment Notice”, there are a number of ways to create enough time to invoice the borrower and let them pay. The ARRC Business Loans Working Group ultimately recommended a “Lookback Without Observation Shift”. A lookback simply starts and ends the interest period a certain number of days early. (Many participants like using a “five business day lookback” because that is generally one calendar week earlier and keeps most “weights” consistent.)
Let’s use a hypothetical and simplified example: Assume a 30-day interest period that begins on Wednesday, April 1, 2020. To figure out the interest for April 1st, the lender would “look back” to Wednesday, March 25th and use the SOFR from that day. For Thursday, April 2nd, the lender would look back to Thursday, March 26th and use the SOFR from that day. And so on for 30 days. The rate used applied to April 30th will actually be from April 23rd…and thus the borrower will know the interest rate for the 30-day period a full week before interest is due. In a Lookback Without Observation Shift, the lender would use the rate from the earlier observation period but the “weight” from the day of the interest period. (In other words, on Wednesday, April 1st, it will use March 25th’s SOFR rate but the “weight” applicable to April 1st. Most days have a “weight” of one, but Fridays have a weight of 3 (to account SOFR not being reported on weekends) and the day before a holiday has a weight of 2 (to account for SOFR not being published on a holiday).) The appendix demonstrates a number of other conventions, but many of them have problematic features (like the possibility of calculating too much or too little interest or occasionally calculating a negative interest accrual) or simply would take too long to program in a timely fashion. All such mysteries are explained with plenty of math, and a number of spreadsheet examples.
Floor Conventions – The Final Frontier: The final, possibly gnarliest, problem in the suite of conventions is how to apply an interest rate floor to a daily rate. As Technical Appendix 4 explains, for loans that i) have a LIBOR floor and ii) fall back from “LIBOR” to “SOFR plus a spread adjustment”, the ARRC recommends economic equivalency. This would mean flooring “SOFR+spread adjustment” at the LIBOR floor level. While it sounds easy – and is easy for a Daily Simple Rate – it’s harder than one would expect for a Daily Compounded Rate. This is because there are two components to this fallback’s interest rate floor: SOFR (which must be compounded daily) and a simple spread adjustment. The easiest way to make this work is to reset the SOFR floor as Legacy LIBOR Floor minus the ARRC Spread Adjustment. (The example in the Syndicated Loans Conventions document notes that if a LIBOR floor is zero and the spread adjustment is 25 bps, then the applicable SOFR Floor would be -25 bps.) An example in the ARRC BLWG Daily Floor Examples demonstrates how to calculate daily interest on a loan that i) had a zero LIBOR floor and ii) fell back from LIBOR to ESTR (which is below zero).
So that was *fun*…The ARRC and the LSTA recognize that this is all very complicated and generally migraine-inducing. But it is important that market participants understand how SOFR works, the potential pitfalls in some of these approaches and the calculations involved to implement them. We’re here to help!