SONIA stands for the Sterling Overnight Index Average. It's the effective overnight interest rate paid by banks for unsecured transactions in the UK. SONIA is an overnight rate and not a term rate. Unlike traditional interest rates, SONIA is based on actual transactions, providing a more accurate reflection of the cost of borrowing.Swap rates, on the other hand, are forward looking fixed interest rates exchangeable for floating rates over an agreed period, typically longer than overnight. Essentially, they are contracts between two parties swapping future interest payments based on SONIA rates. Putting the two together, a SONIA swap rate is the market interest rate to lend or borrow over the agreed period.
Tip: SONIA swap rates are a replacement for UK LIBOR swap rates which were phased out in 2021/2022. You can find current SONIA swap rates here: SONIA Swap Rates UK.
1.2 How are SONIA Swap Rates determined and interpreted?
Here’s where Sonia swap rates come from:
Market Trading: SONIA swap rates are determined in the market where they are traded based on the expectations of future compounded SONIA rates.
Interpretation: A SONIA swap rate reflects the fixed interest rate agreed upon in the swap contract, which will be exchanged for floating payments based on the compounded SONIA rates over the specified period.
Example: Consider the 5-year SONIA swap rate. This rate represents the fixed interest rate that one would receive or pay in exchange for floating payments based on the compounded daily SONIA over the next five years. If the 5-year SONIA swap rate is quoted at 3.75%, it means that market participants expect the average compounded SONIA rate over the next five years to be close to 3.75%. Thus, entering into a 5-year SONIA swap at this rate means agreeing to pay or receive a fixed 0.75% interest rate while the counterparty pays or receives floating payments based on the actual compounded SONIA rates. You can find the current 5 year SONIA swap rate here: 5 year sonia swap rate
Not to be confused with SONIA rates
The daily SONIA rate is a fixing and not a swap rate. Sonia fixings are calculated as the weighted average rate of all unsecured overnight sterling transactions brokered in London by Wholesale Markets Brokers’ Association (WMBA) members between 12am and 3.15pm London time in a minimum deal size of £25m. Sonia fixings are generally used to settle swaps rather than to price them.
SONIA rates are published by the Bank of England and the SONIA chart can be found here: SONIA Chart
1.3 What factors influence SONIA swap rates?
Interest rates are a tool used by the Bank of England to help meet the UK’s 2% inflation target. Factors that influence inflation will therefore impact SONIA swap rates. Here are the key factors:
Economic Conditions: Fluctuations in the UK economy, such as GDP growth or slowdown, can affect borrowing rates and subsequently, SONIA. For example, strong economic growth may lead to higher interest rates as demand for credit increases.
Monetary Policy: Actions by the Bank of England, particularly changes to the base interest rate, directly impact SONIA rates. For instance, if inflation is above the 2% target, the Monetary Policy Committee (MPC) may increase the Bank of England rate, which is likely to push up SONIA swap rates.
Market Liquidity: Higher liquidity in the overnight money markets tends to lower the SONIA rate, reducing swap rates. Conversely, reduced liquidity can increase rates.
Inflation Expectations: Rising inflation expectations typically lead to higher interest rates, including SONIA. If the market anticipates higher inflation in the future, this will be reflected in higher SONIA swap rates.
By keeping an eye on these factors, you can better forecast SONIA rates and make more informed decisions in your financial models.
Example
When inflation is above the 2% target, the MPC might increase the base rate to cool down the economy. This increase would likely push up the SONIA swap rates as the cost of borrowing rises in response.
Pro-tip: As swap rates are constantly traded and volatile, regularly update your financial models with live SONIA swap rate data to ensure accuracy. You can pull data from platforms like BlueGamma to pull in real-time data seamlessly.
What is the difference between Bank of England base rates and SONIA rate?
The BoE base rate is a policy rate set by the central bank, while SONIA is a market-driven rate based on actual transactions.
Purpose: The base rate aims to influence economic activity and inflation, whereas SONIA provides a benchmark for financial instruments.
Frequency of Change: The base rate changes through MPC decisions, whereas SONIA fluctuates daily based on market activity.
Impact: The base rate directly affects consumer interest rates, while SONIA impacts financial contracts and the interbank lending market.
As can be seen from the graph - there is a high correlation but there is a difference in the 2 rates.
2. Calculating interest cost using SONIA Swap Rates
There are 2 approaches that can be used to add sonia swap rates to your financial model, depending on if you are working with a fixed rate or a floating rate instrument
2.1 Simple Weighted Average Life Approach
This approach is straightforward and suitable for quick estimation of the fixed rate applicable
Identify the Appropriate Swap Rate: Match the forecast duration of your debt instrument with the relevant SONIA swap rate. For example, if you are modeling a 5-year debt, use the 5-year SONIA swap rate.
Retrieve Up-to-Date Data: Ensure that you source the most current SONIA swap rates. Websites like BlueGamma provide comprehensive and updated rates.
Incorporate the Swap Rate: Use the identified swap rate to calculate the interest cost over the life of the debt. Multiply the swap rate by the principal amount to estimate annual interest costs, adjusting for the periodicity of the model.
Example
For a 5-year debt instrument with a principal of £10 million and a 5-year SONIA swap rate of 3.85%, the schedule below provides a clear breakdown of the interest payments.
Assumptions
Principal Amount: £10,000,000
SONIA Swap Rate: 3.85%
Semi-Annual Payments
Payment Dates: Every June 30 and December 31
That the swap has been taken out to hedge an underlying loan with the same notional amount. As such, we can assume that the interest on the floating leg of the swap nets off with the interest due on the loan
Schedule
Here's an example of what a typical schedule used to calculate interest payments might look like.
Pro-tip: remember, interest cost calculations are not discounted as they are a cash flow that takes place at a future point in time
2.2 Forward curve approach
This approach is more sophisticated and accounts for variations in interest rates over the period. It is used for floating rate loans or loans with amortisation schedules.
Calculate the amortisation schedule in your financial model: this will depend on the cash flow available for debt service or might be a straight line amortisation
Retrieve Up-to-Date Forward Curves: Pull the forward curve for the relevant dates from platforms BlueGamma (by the way you can download a curve here for free: Sonia forward curve
Calculate interest: in each period, multiple the projected rate by matching the start date for each period in the curve to the start date of your financial model.
Example
For a project finance loan with an amortisation schedule over 20 years, you would derive the repayment schedule by solving for a target DSCR. Be careful for circularity introduced here
Assumptions
Principal Amount: £10,000,000
Forward Rates: Provided below
Semi-Annual Payments
We are calculating the interest cost for a non-amortising floating rate loan
SONIA Forward Curve Data
To use this curve in your model, you can request the current SONIA forward curve here.
Schedule
3. A case study - Analysis of the 5 Year SONIA swap rate chart
Notable Peaks and Troughs in the 5-Year SONIA Swap Rate
June 2018 to December 2019:
Troughs: There were noticeable dips in the swap rate during this period, particularly in the second half of 2018. These troughs coincided with uncertainties surrounding Brexit negotiations, which created market volatility and influenced interest rates.
Peaks: The rate saw a few spikes, reflecting market optimism during brief periods of positive economic news or progress in negotiations.
Early 2020:
Significant Trough: The onset of the COVID-19 pandemic in early 2020 led to a sharp decline in the 5-year SONIA swap rate. The economic impact of global lockdowns and uncertainty caused a flight to safer assets, driving down interest rates.
Volatility: Throughout 2020, the rate experienced significant fluctuations as markets reacted to evolving pandemic-related news, including stimulus measures and vaccine developments.
Late 2020 to Early 2021:
Recovery Peaks: As vaccine rollouts began and economic recovery plans were implemented, the swap rate saw an upward trend. This period marked increased confidence in economic recovery, reflected in rising interest rates.
Mid 2021 to 2022:
Stabilization: The 5-year SONIA swap rate showed signs of stabilization with moderate fluctuations. Market reactions were influenced by the gradual reopening of economies and ongoing fiscal and monetary policies aimed at supporting recovery.
Minor Peaks and Troughs: These were likely responses to periodic economic reports, central bank announcements, and geopolitical developments.
2023 & 2024:
Renewed Volatility: The rate experienced renewed volatility due to various factors, including inflation concerns, central bank rate adjustments, and geopolitical tensions. Each peak and trough during this period can be analyzed in the context of these economic events.
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