On November 21, 2019, the Alternative Reference Rates Committee (the "ARRC") published an appendix (the "Appendix") to the SOFR matrix of SOFR floating rate notes conventions (the "Matrix"), which was published in August 2019. The Appendix contains three "key provisions" for calculating compounded SOFR, a comparison of the three key provisions and a universal SOFR floating rate note ("FRN") fallback provision.1 The three key provisions are lookback, observation period shift and payment delay.

The reason that any of the three provisions might be used by an issuer of a SOFR FRN goes to the nature of SOFR. SOFR is a backward-looking daily overnight rate, as opposed to LIBOR, which is a forward-looking term rate. Among other differences, issuers of LIBOR FRNs and FRN holders know the interest rate for any LIBOR interest period, say three months, at the beginning of the interest period. Consequently, there is certainty and advance notice as to how much interest will be paid to the holder three months hence.

Because SOFR is an overnight rate that is compounded daily during the interest period, the rate for the interest period will not be known until the interest payment date. Interest on FRNs accrues from and including the issue date or the previous interest payment date, to but excluding the following interest payment date or the maturity or redemption date, as applicable. For example, if an interest payment date for a SOFR FRN falls on a Friday, the rate announced on that Friday would be Thursday's rate, allowing the interest rate to be calculated on Friday but with no advance notice to holders and insufficient time to ensure that the paying agent can receive funds from the issuer and then pay the interest payment to holders on that day.

The Appendix details how to alleviate this problem by using any of the three approaches. For a lookback period, the daily SOFR rate for each day in the interest period will be the daily SOFR rate for a certain number of U.S. government securities business days before the date of determination. For example, if the interest payment date was Friday, with interest accruing through Thursday, and a five U.S. government securities business day lookback was in effect, the last daily SOFR rate used for the determination of the compounded SOFR rate for the interest period would have occurred on the Thursday the week prior. Consequently, on the Friday interest payment date, the issuer, paying agent and the holders would have had a week's advance notice of the payment to be made on the Friday interest payment date.2

For the observation period shift, the interest period is shifted back a certain number of U.S. government securities business days prior to the relevant interest payment date. For example, if the interest payment date were to be on a Friday, the relevant interest period would be from and including the Wednesday prior to the previous interest payment date to but excluding the Wednesday prior to the relevant interest payment date. With a two U.S. government securities business day shift, this allows two business days' notice of the interest payment.3

The final approach, payment delay, simply delays payment for two business days after the interest payment date, except at maturity or early redemption. The interest periods run from and including an interest payment date to but excluding the following interest payment date. Consequently, if an interest period ends on a Friday, holders will be paid their interest on the following Tuesday. For the final interest period prior to maturity or early redemption, a "rate cut-off date" or "lockout" is used, so that the daily SOFR rate in effect a certain number of U.S. government securities business days prior to the maturity or redemption date applies to but excluding the maturity or redemption date, as applicable. For example, with a three-U.S. government securities business day rate cut-off date in effect, if the maturity date is a Friday, the SOFR rate on Tuesday will apply from Tuesday through Thursday, and the holder will be paid on Friday. The Appendix contains a number of other technical explanations relating to compounding and the effect of non-business days. The Appendix also contains a SOFR FRN fallback provision, which puts into a logical order the SOFR replacement provisions originally published by the ARRC in April 2019 in the context of a LIBOR fallback, but tailored for a SOFR cessation.4


Originally published in REVERSEinquiries: Volume 2, Issue 11.
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Footnotes

1. The FRBNY Operating Policy can be found at: https://nyfed.org/33KTzG5.

2. In the Matrix, this approach was referred to as "FRNs with Five-Day Lookback and No Lockouts." Note that a "lockout" approach was not used as a main provision in the Appendix, as the market seemed to express concerns that locking in a SOFR rate a certain number of U.S. government securities business days prior to the interest payment date and holding that rate for that number of days created the possibility that an unusually volatile SOFR rate might get locked in for multiple days. However, a lockout is used in the payment delay provision for a brief period prior to maturity or redemption.

3. In the Matrix, this was referred to as "FRNs with a Two-Day Backward-Shifted Observation Period and No Lockouts."

4. We discussed the ARRC's LIBOR fallback provisions in our Legal Update found at: http://bit.ly/2rYcccs.

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