Compounding in Arrears with Syndicated ... - RFR Calculator

Compounding in Arrears with

Syndicated Loan Accruals

Analysis of Interest Payment & Trading Issues / Wednesday, December 2, 2020

Copyright ? 2020 IHS Markit Ltd

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Borrowers

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Compounding in Arrears Interest Calculation

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Agents

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Simple vs. Compound Interest

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Lenders

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Secondary Trading

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Balance Transfer

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Notes

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Borrowers

Compounding in Arrears Interest Calculation

From the Borrower¡¯s perspective, interest will begin accruing on a compound basis following each

interest payment. The calculation is based on the full notional amount of the loan with a risk-free rate

(SOFR, SONIA, etc.) and corresponding year count. As with simple interest loans, secondary trading

amongst lenders throughout the period will have no effect on the borrower¡¯s interest payment amount

for the period.

? Earned Interest = Notional Amount (Compounded) x SOFR x (Day Count / Year Count)

? Initial Commitment = $10,000,000.00, Start Date = 9/30/2019, End Date = 10/31/2019

? Interest Method = Compounding in Arrears

? Other inputs are not necessary for demonstrating this issue: Spread, Adjustment, Lookback, etc.

? Earned Interest due for the Borrower = $16,187.27

Year Count = 360 (SOFR)

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Agents

Simple vs. Compound Interest

With traditional simple interest loans, agents can track lenders¡¯ positions throughout the period and

easily calculate interest due based on each lender¡¯s holding period. However, complications arise

with the compound interest calculation when a lenders position¡¯s change within the period. While the

interest payment being calculated for the Borrower starts compounding on day one, a lender buying

in during the period would reasonably expect their interest to begin accruing on the Settle Date of

their Buy trade.

Continuing with the prior example, the total amount of interest paid by the borrower will equal the

amount accrued by all lenders if the Agent accrues the lenders interest on a daily pro-rata basis

according to their owned percentage throughout the period.

? $4,000,000 was sold from Lender 1 to Lender 2 on 10/10/2019

The agent accruing the lenders¡¯ interest on a daily pro-rata basis will match up with the borrower¡¯s

amount of interest paid, but this secondary trading brings up another issue with which the lenders will

need to contend.

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Lenders

Secondary Trading

With compounding in arrears, using the traditional method of beginning accruals on a Lender¡¯s buy

trade settle date will create a net underpayment of funds to the group of lenders. The discrepancy

stems from the fact that Lender 1 has not only been accruing interest on the trade amount since day

one, but also the interest-on-interest that compounding brings about. It is this second piece that

potentially causes small amounts of interest to essentially ¡°disappear¡± when the loan is traded to a

new lender.

While not common, most lenders are familiar with the idea of including accrued interest on trades.

When an agent simply accrued interest for the lender of record as of the interest payment date (as

shown in the previous section) any discrepancies with a lender¡¯s individual accruals could be

reconciled by including accrued interest on the secondary trades occurring within an interest period.

Compound interest does not work with this same model and other considerations will need to be

made for both buyers and sellers to be compensated fairly.

In the previous example Lender 2 would ordinarily expect to begin their accrual calculations on the

day they entered the deal, aka the buy trade¡¯s settle date. However, based on the agent¡¯s

calculations they will receive the benefit of this prior compounding when buying in mid-period.

For Lender 2¡¯s $4,000,000 trade midway through the period there is a total discrepancy of $2.30. This

additional benefit to buyer (Lender 2) increases with the principal amount purchased and the closer

the settlement date is to the interest payment date.

? Total Interest for Lender 2

? Agent Payment = $4,373.33

? Lender 2¡¯s Expected Payment = $4,371.03 (both calculated above)

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