By Mohamed Z M Aazim, Vikas Pandey and Mac Banda, Debt Management Unit, Commonwealth Secretariat
In this explainer piece, we examine the different methods used by creditors to calculate interest costs under SOFR-based variable interest rate loans. We will also explain why these methods result in nearly identical debt service payments, despite using different ways of calculations.
By mid-2023, global financial markets completed their transition to adopting the Secured Overnight Financing Rate (SOFR) as the premier reference interest rate for calculating borrowing costs for various financial products, including debt.
In our recent policy paper, ‘Is Variable Interest Rate Benchmark Transition Affecting Commonwealth Countries?’, we argued that the recent increase in debt service payments for variable interest rate borrowing is primarily due to the overall increase in U.S. policy interest rates, rather than the transition to SOFR. In response, we explored policy options for developing countries to tackle the debt management challenges arising from variable interest rate borrowings.
Understanding SOFR
SOFR is a benchmark that financial institutions use to price loans for governments, businesses, and consumers. It is a broad measure of the cost of borrowing cash overnight, collateralised by U.S. Treasury securities.
What sets SOFR apart is its daily index value (rounded to eight decimal places), calculated based on the cumulative impact of daily SOFR rates compounded over time.
The SOFR index value had an initial value of 1.00000000 on 2 April 2018, enabling the calculation of SOFR averages over customised time periods.
Interest calculation methods
Sovereign debt contracts typically involve semi-annual interest payments. For SOFR-based loans, creditors use one of the following methods to calculate interest:
- Compounding in Arrears: This method calculates daily compounded interest using the published SOFR rates during the interest period.
- Using SOFR Index: Here, the ‘effective’ interest rate for the interest period is calculated using the published daily SOFR Index Values at the start and end of the period.
- Monthly Rates: Monthly rates are calculated using SOFR index values at the start and end of each month. These monthly rates are then used for each month within the interest period.
Comparing interest costs
To better understand how these methods impact interest costs, we compared interest costs based on these three methods using an illustrative debt contract of USD 10 million, fully disbursed on 1 July 2018. The contract featured semi-annual interest payments starting from 1 January 2019, over a five-year period.
Below is a summary of the interest costs:
|
Due Date |
Compounding in Arrears |
Index Based |
Monthly Rates |
|
01/01/2019 |
$107,545.71 |
$107,568.19 |
$107,568.19 |
|
01/07/2019 |
$123,135.37 |
$123,135.28 |
$123,135.28 |
|
01/01/2020 |
$100,686.94 |
$100,686.94 |
$100,686.94 |
|
01/07/2020 |
$32,782.83 |
$32,782.83 |
$32,782.83 |
|
01/01/2021 |
$4,548.24 |
$4,548.17 |
$4,548.17 |
|
01/07/2021 |
$1,433.43 |
$1,433.44 |
$1,433.44 |
|
01/01/2022 |
$2,533.65 |
$2,533.69 |
$2,533.69 |
|
01/07/2022 |
$20,103.01 |
$20,102.99 |
$20,102.99 |
|
01/01/2023 |
$147,942.79 |
$147,942.83 |
$147,942.83 |
|
01/07/2023 |
$240,666.13 |
$240,665.50 |
$240,665.50 |
|
Total |
$781,378.10 |
$781,399.85 |
$781,399.85 |
As the figures indicate, there is practically no difference in the interest cost irrespective of which method is used. The minor difference is possibly resulting from the rounding applied to the Index Based and Monthly Rates methods.
Policy implications
Regardless of the chosen interest calculation method, the resulting interest costs are substantively the same. Therefore, borrowers are not significantly impacted by the method used to calculate interest for SOFR-based loans.
However, it’s worth noting that multilateral development banks use different calculation methods.
For instance, the Inter-American Development Bank uses the index method, while the World Bank applies the Monthly Rates on its IBRD (International Bank for Reconstruction and Development) loans. Other institutions, such as the African Development Bank, apply the ‘Compounding in Arrears’ method.
What to consider?
Still, there are scenarios where minor differences in interest costs can occur:
- Interest start or end dates falling on non-working days may require using the last published SOFR rate or index values to calculate interest costs. This is the interpolation where determining a value from the existing SOFR values of business days to a non-business day.
- Changes in outstanding debt during the interest period, such as repayments, can result in additional interest components.
- The application of SOFR Term Rates, which encompass daily forward-looking interest rate estimates, can also result in minor differences. The Chicago Mercantile Exchange (CME) Term SOFR Reference Rates benchmark is calculated and published for various tenors (1-month, 3-month, 6-month, and 12-month). And these rates are now used for tracking the interest of loan contracts, particularly as sovereign debt contracts often span durations with defined interest rate calculation cycles.
In conclusion, different calculation methods for deriving interest costs for SOFR-linked debt contracts generally yield similar outcomes.
Policymakers should be aware of the growing adoption of SOFR term rates for long-term financial products and their application for debt management.
Media contact
- Snober Abbasi Senior Communications Officer, Communications Division, Commonwealth Secretariat
- T: +442077476168 | E-mail
