Term SOFR – daily SOFR divergence
Term SOFR is an index rate frequently used in floating-rate loans and notes. It is published by the Chicago Mercantile Exchange (CME Group) in tenors of one, three, six, and 12 months and reflects market expectations for spot SOFR (an overnight rate) for that given tenor. This piece examines situations where actual spot SOFR rates deviate from their forward expectations as implied by Term SOFR and some of the market dynamics that may cause those deviations.
- Term SOFR is a forward-looking index rate published by the CME Group designed to provide a term structure for SOFR to be used in floating-rate loans and notes.
- Term SOFR captures market expectations for daily spot SOFR rates for a given tenor (one, three, six, and 12 months).
- Over long periods of time, Term SOFR should reflect average daily SOFR rates; in the short run, actual daily SOFR rates may deviate from forward expectations reflected in Term SOFR.
- In practice, material deviations will occur if the Federal Reserve makes unanticipated policy decisions with respect to the fed funds target rate.
Term SOFR is a forward-looking term index rate published by the CME Group used as an index in many floating-rate loans. It was created to provide a term structure for SOFR, an overnight rate based on repo transactions. It is derived by looking at where futures contracts tied to SOFR trade relative to current SOFR rates – it reflects a “betting line” for what SOFR will average over a given term (with CME calculating and publishing one, three, six, and 12-month versions). Term SOFR provides a way for floating-rate loans to reset in advance, at the beginning of an interest period, with a term rate.
Over a long period of time, a given tenor of Term SOFR should be consistent with actual daily spot SOFR rates. For example, a borrower should be indifferent to paying interest based on 1-month Term SOFR rate, reset monthly, or interest based on spot SOFR, reset daily. Over shorter periods of time, like a single monthly interest period on the loan, this may not be the case. Since Term SOFR reflects the expected average of daily SOFR over a given term, to the extent that actual daily SOFR rates diverge from expectations at the time a given Term SOFR rate is observed, the two will diverge. The two graphs below show this. The first shows a time series of 1-month Term SOFR and the realized average of spot SOFR over the succeeding 30 days; the second shows the difference between the two.
Since SOFR is based on repo rates, this divergence occurs when repo rates change unexpectedly. This can occur as a result of an idiosyncratic event in the treasury repo market. With the increased role that the Federal Reserve plays in supporting liquidity in the repo markets (through their Reverse Repo Facility and their Standing Repo Facility, which support lower and upper bounds on repo rates), unexpected changes in repo rates generally now only occur in the context of unexpected policy decisions by the Fed on the target fed funds rate. In practice, unexpected changes in SOFR (and divergence from Term SOFR) would occur when the Fed hikes, cuts, or holds steady the fed funds rate in a matter not predicted by forward rates in the market (since the fed funds rate is the biggest driver of repo rates and SOFR).
This can be in favor of, or detrimental to, a borrower during an interest period. If the Fed unexpectedly cuts rates, actual daily SOFR rates will decline in a way not reflected in the Term SOFR rate used at the start of the loan interest period – the borrower will have paid an interest rate based on expectations for SOFR that were higher than realized SOFR. Conversely, if the Fed unexpectedly increases rates, a borrower will have paid an interest rate based on expectations for SOFR that were lower than realized. In either case, the impact of this divergence is just felt for a given interest period.
Have questions about the divergence between spot SOFR and Term SOFR?
Contact a Chatham expert today.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.23-0105
Our featured insights
Expert Conversation with Matt Henry and Rob Kaplan
Matt Henry, Chatham's Managing Partner and CEO, and Rob Kaplan, former President and CEO of the Federal Reserve Bank of Dallas, discuss the economy, alternative capital sources, interest rates, and more.
BoE holds rates steady again while ECB pauses record run of hikes
The Bank of England (BoE) kept rates on hold at 5.25% for a second consecutive meeting today, as it attempts to balance a weakening economy with inflation that is still measuring three times its target. The Bank's updated forecasts show medium-term inflation slightly higher than in August's...
Fed holds rates steady while noting tighter financial conditions
On Wednesday, November 1, 2023, the Federal Open Market Committee (FOMC) voted unanimously to hold the fed funds rate at a target range of 5.25%–5.50%. Today's pause represents consecutive FOMC meetings with no rate change, having hiked in 11 out of the last 14 prior meetings. The most notable...
Capital Markets Sentiment Report
This report’s data comes from five poll questions answered during a live Chatham webinar held on September 21, 2023, hosted by Amol Dhargalkar and Jackie Bowie. We polled over 1,500 respondents spanning various industries, including commercial real estate, corporates, financial institutions, and...
Chatham Financial announces CEO transition effective January 2022
Matt Henry named the next Chatham CEO
Interest rate swaption
An interest rate swaption is an option that provides the borrower with the right but not the obligation to enter into an interest rate swap on an agreed date(s) in the future on terms protected by the swaption.
Interest rate swap and floor
An interest rate swap and floor is a combination of an interest rate swap with the purchase of an interest rate floor.