SOFR and floating-rate notes: How a bond’s interest rate can move with the market

A floating-rate note is a bond whose interest payment is not fixed in advance. Instead, it follows a benchmark rate plus a set margin. In the US dollar market, that benchmark is now usually SOFR, short for the Secured Overnight Financing Rate, which the Federal Reserve Bank of New York publishes every business day.

Think of an adjustable-rate mortgage. The lender does not promise one rate for 30 years. The rate follows a market index and is reset on a schedule. A floating-rate note works the same way, except the borrower is a company and the lenders are bond investors.

Why Microsoft’s filing lists two series that pay SOFR plus a margin

In our report on Microsoft’s reported $25 billion bond sale, the preliminary SEC filing describes ten series of senior notes. Eight pay a fixed rate twice a year. Two are floating-rate: they pay compounded SOFR plus a margin, and the rate resets quarterly.

The filing leaves the amounts, maturities and margins blank. Those are normally set when the deal is priced. So the useful question is how the floating formula works, not what number it will produce.

Building the rate from an overnight price

SOFR measures the cost of borrowing cash overnight when the loan is backed by US Treasury securities as collateral. The New York Fed says it covers a broad set of such repurchase (repo) trades, and it is calculated as a volume-weighted median of the transactions. The rate is published at about 8:00 a.m. Eastern Time on each business day.

A bond does not pay interest overnight, so the overnight rates must be combined. The usual method is compounding: each day’s rate earns interest on the interest of the days before it, like a savings account that credits interest daily. The note pays that compounded SOFR for the period, plus the margin.

The margin is the part that reflects the borrower. A company seen as riskier pays a larger margin over the benchmark. SOFR itself carries no view on any one company.

Why the rate is known only at the end

Compounded SOFR is calculated in arrears. The final rate for a quarter is known only once the quarter’s daily rates are in. That is awkward for payments, because the issuer needs the amount a few days before it pays.

Notes solve this with a lookback. Each day’s rate is taken from a few business days earlier, so the total is ready in time. Some notes also shift the observation period so the rates line up with the days of the interest period. The Alternative Reference Rates Committee (ARRC) published model term sheets for these conventions. The exact choice for any note is spelled out in its offering documents, and Microsoft’s final terms are not yet public.

The New York Fed also publishes three daily compounded averages of SOFR and a SOFR Index. The index lets anyone compute a compounded rate over a custom period.

Where SOFR came from: The end of LIBOR

Before SOFR, most floating-rate dollar debt used LIBOR. The New York Fed describes LIBOR as not anchored in actual market activity, which left it open to manipulation. In 2017 its regulator said it could not guarantee LIBOR would exist after 2021.

That same year the ARRC, a group formed in 2014 to guide the switch, selected SOFR as the replacement. US regulators told banks in November 2020 to stop new USD LIBOR use from December 31, 2021. All USD LIBOR panel settings ceased on June 30, 2023.

The New York Fed points to the repo market’s daily volumes, which it says exceed $1 trillion, as a reason SOFR is hard to manipulate and unlikely to be discontinued. It also notes a forward-looking variant, Term SOFR from CME Group. The ARRC recognized it only for a limited scope: legacy products and certain new business loans.

What floating notes trade away, and what to watch

For the buyer, a floating note offers protection when rates rise: the interest follows the market. The cost is predictability. If rates fall, the payments fall too, and nobody can say today what the note will pay in three years.

For the issuer, the trade-off is the mirror image. A fixed-rate bond locks in a known cost. A floating one lets the cost rise and fall. Companies often sell both kinds in one deal, which splits the offering across investors with different needs. That is one reason a single sale can have ten series.

Two limits are worth keeping in mind. First, SOFR is a secured, near risk-free rate, so the margin does all the work of pricing credit. Second, the New York Fed’s pages describe the benchmark and the compounding tools. They do not say what any particular note will pay.

For Microsoft’s sale, several things are worth watching:

• Whether the final prospectus confirms the total size Bloomberg’s sources reported, at least $25 billion.
• How much of the total goes into the two floating-rate series versus the eight fixed-rate ones.
• The margins over compounded SOFR, which will show how the market prices the company’s credit.
• The lookback and observation conventions, which appear in the final terms.