Of coupons, yields, rates and spreads Part II: SOFR and risk-free rate
This article is part two of a series on fixed income investing – read the first part here.
Key takeaways
- The risk-free rate is a benchmark rate for sovereign bonds or an investment with theoretically zero risk. The three-month US Treasury bill (T-bill) is used as a proxy for the risk free rate.
- Spread is the premium investors require on top of the risk free rate to invest in an instrument inherently riskier than a Treasury security.
- SOFR, or the Secured Overnight Financing Rate, is a daily benchmark value that measures the cost of borrowing cash overnight when it’s collateralized by Treasury securities.
Coupons, yields and rates are key concepts in fixed income investing – they can help value a fixed income opportunity, better understand market fluctuations, and calculate potential returns of a debt opportunity. These terms also diverge into more specific concepts like risk free rate, spread and SOFR, which help assess risks related to the issuance or the issuer, as well as the current macro conditions.
Risk free rate and spread
“Rate” is sometimes used synonymously with risk-free rate, or the benchmark rate for sovereign bonds, which is theoretically an investment with zero risk. In practice, there’s no investment with truly zero risk, but the chance that the US government would default on debt is so low, that the three-month US Treasury bill (T-bill) is used as a proxy for the risk free rate.
As the risk-free rate increases, the price of the bond decreases and vice versa. This is because the value of future cash flows, which are the coupon payments + the principal at maturity, has to be discounted by the higher risk free rate.
Spread, another key concept in debt investing, is the premium investors require on top of the risk free rate to invest in an instrument inherently riskier than a Treasury security. For example, if the risk-free rate is 2%, and a bond’s coupon is 5%, the spread would be about 3%.
Spread is associated with the specific risk related to the issuer. The ~3% spread, also called “excess return” is really the investor’s compensation for taking the additional risk on top of the risk free rate.
What happens to risk free rate in times of inflation?
Inflation changes the way excess return is interpreted– what might look like an attractive return at one time, can become less attractive if inflation increases. To factor in inflation, there’s a derived measure called the real risk free rate, which is the difference between the nominal risk free rate (or the current yield of the T-bill) and the current rate of inflation.
REAL RISK RATE = NOMINAL RISK FREE RATE – INFLATION RATE
If the T-bill has a current yield of 2% (=risk free rate), a bond yielding 2.5% might seem attractive at first glance because it has excess return, but at the current inflation rate of 8.6%, that same bond would be 6.1% (=2.5-8.6) short of keeping up with current inflation rates. These kinds of considerations are often at the core of investors’ assessments when judging a bond based on yield and rate of return.
SOFR and interest rates
Another influential benchmark rate is the SOFR, or the Secured Overnight Financing Rate, which is used to price U.S. dollar-denominated derivatives and loans. It measures the cost of borrowing cash overnight collateralized by Treasury securities, using approximately $900 billion worth of daily market transactions. While the mechanics of a SOFR value calculation is complicated, broadly speaking, it’s the median value of that day’s market transactions weighted by volume, which is pulled daily from both the Bank of New York Mellon and The U.S. Department of the Treasury’s Office of Financial Research (OFR.)
Because SOFR determines the way debt structures like loans are priced, high variance in its value has real implications for investors. Like many other benchmarks, SOFR can also change in response to economic activity, which in turn correlates with monetary policies like Fed’s interest rates. Amid recent rate hikes for example, SOFR has been steadily rising, and is currently at 1.5%, compared to 0.05 on 16 March, when the Fed first raised interest rates. Like risk free rates, SOFR values can be an important consideration for investors looking to get meaningful return – if SOFR values are so high that the spread is nominal, a deal that looked more attractive under other circumstances might not be in times of economic strain, which might drive investors in search of yieldier returns.
Yieldstreet and private markets
With volatility in rates being a staple of current market conditions, Yieldstreet launched a floating-rate loan offering, supporting the acquisition of a specialized car insurer with strong fundamentals and growth potential. The loan rate is expected to be 7% above the 1-month Secured Overnight Financing Rate (SOFR) – which is currently 1.5% and may increase as the Federal Reserve is tightening rates.
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