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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.

Key takeaways

  • 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.

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