February 19, 2020 - The SOFR Index (and Averages) have created considerable buzz in the loan space. The good news: Last week, the New York Fed announced it would start publishing them on March 2nd. The bad news: Due to various loan idiosyncrasies, these tools – while still beneficial! – may be less useful than for other asset classes. We explain all below.
First, what are these tools? The Fed explained that the SOFR Averages would be 30-, 90- and 180-day Compounded Averages of SOFR. These would be official, published rates that can be referenced in contracts, potentially including loan contracts. The rates would be compounded on business days and use a simple average on weekends and holidays because that is the convention in the swaps market. The averages will be published daily, corresponding to exactly the previous 30, 60 and 90 days, regardless of whether the start date was a weekend or holiday. The calculation, which is fun to look at, but mostly useful for grecophiles, is available in the Fed’s announcement. Importantly, the Fed has not yet published 1-month, 3-month and 6-month SOFR Compound Averages because that is actually far more complicated. However, there is appetite for those rates and the Fed continues to consider their development.
The Fed also announced that the long-awaited SOFR Index would debut March 2nd. In effect, the SOFR Index simply takes (1+ starting SOFR) – April 2, 2018 – and compounds it by SOFR for every business day thereafter to create an Index level. (Again, simple SOFR is used on weekends and holidays.) The fabulous thing about the SOFR Index is that one can determine the compounded SOFR rate for any period by the following calculation:
(SOFR Indexend/SOFR Indexstart – 1)
(360/calendar days from start to end)
Thus, it is a very useful tool. So why did we caveat that these tools might be somewhat less useful for loans? The reality is that the Index is very useful if there are no intraperiod prepayments on a contract. Once there is an intraperiod prepayment – as there often are on syndicated loans – and principal is no longer constant, one can no longer just use one start date/end date Index ratio to calculate the interest due. Instead, one may need multiple calculations for the pre-prepayment interest due and the post-prepayment interest due. It gets complicated.
Meanwhile, the SOFR Averages are very useful if a contract is using “SOFR Compounded in Advance”, whereby the interest rate for the coming period (say April 1-June 30) is based on the interest in the previous period (Jan 1-Mar 31). It is also very useful if the counterparties do not accrue daily and just apply a Compound SOFR Average rate at the end of the period and principal does not change. However, the syndicated loan market has pretty decisively disdained “Compounded in Advance”, noting it creates significant asset-liability management problems. Meanwhile, loan counterparties accrue interest daily – and some, like mutual funds, strike a daily NAV and meet redemptions daily based on that NAV – which makes an “end of period” interest rate less compelling. But that’s definitely not to say there’s no use for such an Index or Average in the loan market. The reality is that Average SOFR rates could have other uses. For instance, average SOFR rates could be built into trade confirms for “Cost of Carry”. Moreover, the SOFR Index can work as an excellent third party check on interest calculations, assuming principal does not change during the period. Even if they are not a perfect fit for loans, the SOFR Index and Averages are an important step forward.