Determining the Fallback Rate – Adjusted RFR, Reset Dates and Spread Adjustments
The Adjusted RFR and the Spread Adjustment are summed to arrive at the 'all in' Fallback Rate published by Bloomberg. These terms, and other relevant concepts, are explained below.
The Adjusted RFR aims to extrapolate from the overnight RFR a term RFR which reflects the tenor of the LIBOR setting it is replacing. While LIBOR term rates are forward-looking over the relevant tenor (e.g. one-month LIBOR reflects the cost of borrowing for the coming month), the Fallback Rates are backward-looking and are calculated on the basis of overnight RFRs (e.g. SONIA reflects the cost of borrowing over the previous night).
To determine the Adjusted RFR and replicate the characteristics of LIBOR tenors, Bloomberg therefore compounds the RFR (e.g. SONIA) each day over an "Accrual Period" the duration of which corresponds to the affected tenor of LIBOR. The compounded rate is then annualised, and the day-count convention is matched to that of LIBOR.
The Accrual Period will begin on or just prior to the Reset Date (e.g. for SONIA it will begin two days prior to the Reset Date, but RFRs in different currencies have different conventions), and it will finish the day which is the length of the affected LIBOR tenor from the Accrual Period start date.
As compounding is applied daily by Bloomberg during the Accrual Period, using the new SONIA overnight rate each day as an input to the compounding formula, the parties will not know the Adjusted RFR until it is published at the end of the Accrual Period.
Function of Reset Dates under Fallbacks Supplement
In existing LIBOR-based swaps, the "Reset Date" will be set to fall at or just before the start of the Calculation Period over which interest is calculated. As the LIBOR tenors are forward-looking, parties could simply read the screen rate on the Reset Date and apply that rate to the Calculation Period.
Under the Fallbacks Supplement, as the Adjusted RFR is not published until the end of the Accrual Period, which starts just prior to the Reset Date, the Reset Date itself is no longer the date on which the screen rate is observed. Instead, under the Fallbacks Supplement, the parties apply the screen rate for the Fallback Rate for that Reset Date on a "Fallback Observation Date", which is a date falling two days prior to the interest payment date.
Under the Fallbacks Supplement, the Reset Date therefore operates to reset the perimeters of the Accrual Period over which Bloomberg conducts the daily compounding of SONIA in order to publish the compounded "term" RFR rate on the Fallback Observation Date.
Having calculated the Adjusted RFR, Bloomberg applies the Spread Adjustment to arrive at the Fallback Rate. The Spread Adjustment aims to capture the element of LIBOR which represents bank credit risk over and above RFRs.
Prior to the Announcements, Bloomberg was publishing a daily indicative Spread Adjustment calculated as the median spread between LIBOR and the Adjusted RFR over the preceding five-year period, ending on the day which falls on Reset Date minus the relevant tenor, minus two business days.
On 5 March 2021, Bloomberg published the fixed Spread Adjustments for all relevant LIBOR tenors. The announcement can be found here.