Basics of Interest Rates: Difference Between LIBOR & SOFR Rates
Today, we’re going to talk a little bit about interest rates and what’s going on and what’s happening and what some of these words and terms mean and what they’re going to mean to you. It’s going to be pretty elementary.
Historically, companies have borrowed money and banks have borrowed money between and among each other at a rate called LIBOR.
As you’ve been listening and hearing, if not in the news, you should have been hearing it from your banks, LIBOR is going away, and the marketplace has deemed that SOFR is going to be the replacement for LIBOR.
LIBOR vs. SOFR Rate
So let’s first talk about what the difference is between the LIBOR rate and the SOFR rate.
So your LIBOR rate, if you had one-month LIBOR or three-month LIBOR terms, you had a rate that set in advance and was paid in arrears. So they would tell you at the beginning of the month what the rate is, you’d know how much your debt was, and you could figure out how much you’re going to pay at the end of the month.
With SOFR, we kind of have a daily rate and then they’re starting to develop term SOFR. So term SOFR just means we would again set the rate at the beginning of the month, you would know in advance and then you do your calculations and pay in arrears.
But most SOFR contracts are going to be actually kind of calculated in arrears based on what the SOFR daily rate was during the month. So it would be calculated in arrears and paid in arrears. So you actually don’t know how much you’re going to be paying until the end of the month.
So there was kind of this big expectation then that all of you were going to have your bank show up and start talking to you about SOFR. And again, SOFR would have differed from LIBOR because LIBOR had kind of what we consider the risk-free rate, which is SOFR overnight rates, plus a credit spread for the banks, kind of taking into account the bank’s credit – the group of banks’ credit. Under SOFR, because you’re getting a risk-free rate, the banks actually have to add an additional spread to get you kind of from that SOFR risk-free concept to the fact that they have to borrow money and then add your credit on top of that.
So you would have SOFR plus the spread plus your credit spread. So getting a little bit more complicated. Most of you are probably now expecting your banks to come in and talk to you about SOFR.
If you have hedges to adapt your hedges to SOFR, which is what the ISDA has come up with, that you would switch to SOFR.
But all of a sudden some of your banks are showing up with other rates. Maybe suggesting they’ll take you to BSBY or to Ameribor. These rates are an attempt to, instead of confusing you with will you have SOFR, and then we’re going to have this credit spread for the bank – they’re trying to collapse those back down into a single rate, plus your credit rate.
There is some difficulties with this because of valuations. If you have derivatives that are off of BSBY or SOFR, those markets or even a little bit less liquid, a little less transparent. So we don’t know exactly how difficult that is going to be a longer run in getting good valuations on those instruments.
But that’s what’s happening with interest rates. Hope you’re staying on top of it. Let us know if you have any questions or need any help.