- How to adapt risk-free rates (RFR) (SONIA and SOFR) for use in forward-looking cash products such as loans; and
- How to calculate interest over an interest period to make RFRs operationally functional.
How is the issue of overnight RFRs being adapted to deal with forward-looking interest tenors?
- The working groups and committees involved in the transition to RFRs have focused on creating a forward-looking rate that can be calculated at the commencement of an interest period and the operational issues around this.
- The currently feasible calculation of SOFR or SONIA, which has found some market acceptance, is to average overnight interest rates accruing during the course of an interest period. Averaging overnight rates for a given interest period accurately reflects movements in the respective RFRs over that period and smooths out day-to-day fluctuations in market rates.
- The method of averaging is still being considered, but is currently limited to a discussion of simple averaging versus compound averaging.
- By the “simple averaging” method, interest is calculated each day on the principal amount borrowed and added up at the end of the interest period. This is easier to calculate from an operational perspective.
- By the “compound averaging” method, interest for each day would be compounded to more accurately reflect the reality that a loan is not being repaid and reborrowed each day of the period. The ARRC has found that historically the difference between simple and compounded interest on SOFR would have ranged between 0 and 10 basis points over the last two decades.
- Once the method of calculating interest over a given interest period has been determined, the operational issue of when and how the interest is paid by the borrower needs to be addressed.
- Under LIBOR-based contracts, the interest rate is determined at the beginning of the interest period. As noted above, RFRs are calculated on an overnight basis with the averaged rate only being known at the end of the relevant interest period. This creates cash-flow issues for borrowers who will not know the cost of borrowing until the payment falls due. Over the term of the loan, historical data shows that any variations caused by actual overnight rates being used (as opposed to forward-looking rates being set at the start of an interest period) will broadly net out; the ARRC has calculated that on a hypothetical five-year loan the forward-looking/average overnight rate difference is only +/- 5 basis points.
- Conventions are being developed to give borrowers sufficient notice of the amount of interest due before they are required to make payment. These include:
- Payment Delay – interest for an interest period is paid k days after the start of the next period (overnight index swaps (OIS) generally use a payment delay to settle of T+2).
- Lockout or Suspension Period – using averaged RFRs over the current interest period with the last rates set at the rate fixed k days before the period ends (typically a period of two to five days).
- Lookback or Lag – for every day in the current interest period, use the RFR rate from k days earlier so that the actual reference period lags by k days such that it starts and ends k days after the RFR reference period. (A three-to-five day lookback period has been used for SONIA floating rate notes.)
- Other hybrid models are also being considered, such as principal adjustment where payments are set in advance but principal and interest accrue in arrears, and interest rollover, where payments are set in advance and any missed interest relative to in arrears is rolled over into the next interest period.
- The UK Working Group for Sterling Risk-Free Reference Rates has considered the above conventions and has suggested that given that the lag convention provides a degree of certainty for a given number of days at any point during the interest period, and that it is easier for market participants to adopt and avoids the risk of locking in rates at unusually high/low rates leading to disproportionate changes in the compounded/average rate, the lag convention is to be preferred. Given that certain new issuances of SONIA-referenced bonds have adopted the lag mechanism, the market is also relatively familiar with the concept.
Next in the Series
On April 25, 2019, the Alternative Reference Rates Committee (ARRC) published the document “ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans” which sets out the ARRC recommendations for provisions to be added to new loan facility documentation. In our next installment, we will consider the ARRC’s recommendations.
(For additional information on this topic, contacts the authors or Daniel Budofsky, Joseph Fastiggi, Michael Reese or Russell DaSilva.)