SONIA remains the Working Group’s recommended alternative to Sterling LIBOR, implemented via a compounded in arrears methodology, and loan markets should now move consistently towards this.
Use of a Five Banking Days Lookback without Observation Shift (referred to as the lag approach) is recommended as the standard approach by the Working Group. This aligns with the approach recommended by the Alternative Reference Rate Committee for US dollar loan markets and in the Working Group’s view is most likely to be made rapidly available. Whilst this approach is the recommendation, where lenders are also able to offer lookback with an observation shift this remains a viable and robust alternative (see the worked examples for the comparison between these two approaches).
Where an interest rate floor is used, the Working Group recognises that it may be necessary to apply the floor to each daily interest rate before compounding.
The Working Group recommends that accrued interest should be paid at the time of principal prepayment.
So, lag is the recommendation but the door remains open for shift if parties want to use it. It feels like we've been talking about conventions forever... see 'conventional wisdom' from last year.
Of the various compounding methods, the Bank has not explicitly recommended a specific approach but has stated the market favours compounding the rate rather than compounding the balance. However, there are two compounding the rate options – Cumulative Compounded Rate and Non-Cumulative Compounded Rate. Whilst both return the same result, the latter deals with interim events (e.g. a prepayment) more cleanly. The supporting slides do suggest Non-Cumulative is recommended (page 7).
Where this leaves the bond market isn't that clear noting a desire by some to use the BoE Index which naturally takes you back to shift.
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