Term SOFR vs Swap rate

Navigating the nuances between Term SOFR, Swap Rates, and how they interact within financial markets can indeed be complex. Let's break down the concepts to clarify the differences and address your observations regarding Bloomberg's pricing and curves.

1. SOFR (Secured Overnight Financing Rate): This is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. It's based on actual transactions in the Treasury repurchase market, making it a robust benchmark for short-term interest rates.

2. Term SOFR: This refers to the forward-looking rate derived from SOFR futures contracts, indicating market expectations for the average SOFR rate over a specified term in the future, such as 10 years. It's important to note that Term SOFR is a relatively new concept and is being developed to provide a benchmark for longer-term financial products.

3. Swap Rate: In the context of an Interest Rate Swap (IRS), the swap rate is the fixed interest rate that one party agrees to pay in exchange for receiving a floating rate (based on a reference rate like SOFR) from another party. The swap rate is determined at the outset of the swap and remains constant throughout the life of the swap.

4. Differences and Confusion: The confusion might arise from the fact that both Term SOFR and the swap rate in an IRS involving SOFR as the floating leg can reflect long-term interest rate expectations. However, they serve different purposes. The Term SOFR is a projection of the SOFR rate itself over a future period, while the swap rate is the fixed rate agreed upon in an IRS contract, which could be influenced by various factors including credit risk, liquidity, and market expectations.

5. Bloomberg Observations: When you price an IRS with 1-day SOFR and a 10-year term, the resulting 10-year swap rate reflects the market's expectation for the fixed leg of the swap. If this rate appears similar to the 10-year Term SOFR, it might be coincidental or reflect market alignment on long-term SOFR expectations. However, discrepancies between the Term SOFR and the swap curve (USD OIS Curve) can occur due to different market dynamics, underlying transactions, and liquidity in the instruments used to derive these rates.

6. GBP SONIA vs. USD SOFR: The observation that SONIA (Sterling Overnight Index Average) aligns with the GBP OIS curve, while SOFR and the USD OIS curve might diverge, highlights differences in market structure, liquidity, and the maturity of these benchmarks. SONIA has been established longer than SOFR, potentially leading to greater consistency in pricing and expectations.

In summary, while Term SOFR and swap rates both reflect expectations for future interest rates, they are distinct concepts used for different purposes within financial markets. Discrepancies in rates and curves can arise from various market factors, including liquidity, credit risk, and the specific instruments and transactions underlying each benchmark.

Sources: Pick Your Poison | The Daily Peel | 10/6/21, Loan Terms, Q&A: Non-Target School to Portfolio Manager at a Top Hedge Fund – 6 Years Out of Undergrad, For love of the game, Q&A: First year macro hedge fund analyst