SOFR Explained: What Every Borrower Needs to Know

Understanding SOFR: A Practical Guide for Borrowers Hedging Interest Rate Risk

If you’re a borrower with a floating-rate loan, or if you’re entering into an interest rate swap or cap, your transaction will be based on the Secured Overnight Financing Rate (SOFR). SOFR is now the standard benchmark for virtually all U.S. dollar-denominated floating-rate debt and derivatives. Understanding how SOFR works, and specifically which version of SOFR your loan uses, is important because it directly affects your hedging costs and options.

What Is SOFR?

SOFR is published daily by the Federal Reserve Bank of New York. It measures the cost of borrowing cash overnight using U.S. Treasury securities as collateral. Because it is based on actual transaction data from the Treasury repurchase agreement market (one of the deepest and most liquid markets in the world), SOFR is considered a robust and reliable benchmark. However, because SOFR is an overnight rate, it does not have a built-in term structure the way the old benchmarks did. The industry has adopted several conventions for using SOFR in loans and derivatives, and the choice of convention has a real impact on your hedging costs. The three most common are Term SOFR (a forward-looking rate for 1-month or 3-month periods, published by CME Group), daily simple SOFR (the overnight rate applied each day and summed over the interest period), and compounded SOFR in arrears (the overnight rate compounded daily over the interest period, with the final rate determined at period end).

Why the Type of SOFR in Your Loan Matters for Hedging

This is one of the most overlooked opportunities for borrowers to save money on hedge execution, and it starts before you even lock your swap or cap. Most borrowers don’t realize that the SOFR convention specified in their loan documents directly affects the cost of the interest rate hedge they’ll need to execute. Term SOFR is the most borrower-friendly convention from an operational standpoint: you know your rate at the beginning of each period, just like the old benchmarks. But Term SOFR-based swaps and caps carry higher execution costs because the interdealer swap market prices off overnight SOFR, not Term SOFR. When you hedge a Term SOFR loan, the bank’s swap desk must account for the basis risk between the two rates, and that cost gets passed to you in the form of a wider spread. On a daily simple SOFR or compounded SOFR in arrears loan, hedging is more straightforward and less expensive because the hedge aligns more naturally with how the interdealer market actually functions. The savings can be several basis points on the swap rate, which on a large or long-dated transaction, translates to meaningful dollars over the life of the hedge. This means there is a real opportunity to negotiate the SOFR convention in your loan documents before the loan closes. If your lender is flexible on the convention, choosing daily simple SOFR over Term SOFR can reduce your hedge execution costs while still achieving the same economic outcome: a known fixed rate on your debt. Not every lender will accommodate this, and there are operational tradeoffs to consider, but it is a conversation worth having, and one that an independent swap advisor can help you navigate.

Fallback Language and Documentation

Your swap or cap documentation should include clear fallback language specifying what happens if SOFR is temporarily unavailable or if the benchmark methodology changes in the future. Well-drafted fallback provisions protect both parties from disruption. Additionally, if your loan uses one SOFR convention (such as Term SOFR) and your hedge references a different one (such as compounded SOFR in arrears), there will be basis mismatch between the two. An independent advisor ensures that your hedge documentation aligns properly with your loan terms so you aren’t left with residual floating-rate exposure you didn’t expect.

Evercrest Can Help

Whether you’re entering a new SOFR-based swap, evaluating a rate cap, or trying to understand how the SOFR convention in your loan affects your hedging costs, Evercrest can help. We work with borrowers to make sure the hedge structure, pricing, and documentation all align, and that starts with understanding the benchmark your loan is built on.

Email: info@evercrestadvisors.com | Phone: 212-837-8900