November 6, 2019 - SOFR tools are coming! On November 4th, the FRBNY released a request for public comment on an official “SOFR Compound Average” and a “SOFR Index”. Below, we describe these tools, their use cases and several questions from the consultation. The LSTA is considering responding, either in its own capacity or in its role as co-chair role of the ARRC’s Business Loans Working Group. Please contact firstname.lastname@example.org for more information.
The first tool is a set of official Compound Averages of SOFR for the previous 30, 90 and 180 days. (While “indicative” Compounded SOFR and Forward Looking Term SOFR rates already are available, these would be official compounded SOFR rates.) The benefit of the official rates is that by simply plucking them off a screen, borrowers and lenders would know the compounded SOFR for those periods. This could be particularly useful for products that use “SOFR Compounded in Advance”, i.e., the SOFR that is determined by compounding the daily SOFR rate before the interest period begins.
However, for syndicated loans, there does not appear to be significant appetite for “SOFR Compounded in Advance”. Thus, an index for SOFR Compounded in Arrears may be potentially more useful. Basically a SOFR Index would internalize compounding for a SOFR Compounded in Arrears product. As the consultation demonstrates on p. 5, the Index would start at “1” on the first day SOFR was published – April 2, 2018 – and be compounded by the SOFR rate every day thereafter. There are (at least) three very nice things about the SOFR Index. First, it would automatically internalize all the day count, rounding, weighting, “lookback” and compounding conventions that the market decides to use. Thus, it would not be possible for a borrower and lender to inadvertently use different conventions and therefore calculate different interest payments. (This is a real threat.) Second, it very much simplifies the process by which systems would compound interest rates. Instead of pulling SOFR daily and compounding inside a system for every loan, a loan system can simply pull the SOFR index and do the following simple calculation to determine the accrued interest for any period of time:
(SOFR Indexend / SOFR Indexstart – 1)
(360 / calendar days from start to end)
This is far less complicated than the internal calculation (see p. 20 of recent ARRC minutes for a numerical example). Third, it will be very easy to build “SOFR Calculators” for unsophisticated parties to see what their interest rates are and how their interest charges are accruing. Thus, the SOFR Index could simplify a “Compounded in Arrears” world substantially. But there’s (always) a but: An index works very well in a world where all principal prepayments are accompanied by interest payments at the same time. However, that is not always the case in the business loan world. If interest is not repaid at the time of a principal prepayment, then interest must be calculated off the changing outstanding balance of the loan. In this scenario, the Index is potentially less useful.
The LSTA is considering responding to the consultation. While there are a number of questions on p. 6, one we may address is:
- Are there any other changes to the averages or index as proposed that would make them more useful? For what purposes? (We might suggest the development of an official “SOFR Calculator”, which would use the equation above to permit counterparties a “golden source” of interest charges for a certain period. And, as absurdly simple as it seems, we might recommend the development of “simple SOFR” calculator and averages that counterparties could use as a final check on interest rates for a period.)
Responses are due December 4, 2019. If LSTA members would like to engage in this process, please reach out to email@example.com.