What Is Quality Spread Differential?
Quality spread differential (QSD) is used to calculate the difference between market interest rates that two parties potentially entering into an interest rate swap are able to achieve. QSD is a measurement that companies can use to gauge counterparty risk in an interest rate swap.
- A quality spread differential is the difference between market interest rates achieved by two parties who enter an interest rate swap.
- The QSD is used by companies of different creditworthiness.
- The QSD is calculated by subtracting the contracted market rate by the rate available to the counter-party on similar rate instruments.
The Basics of the Quality Spread Differential
A quality spread differential is a measure used in interest rate swap analysis. This tool is used by companies of different creditworthiness. They use a quality spread differential to gauge default risk. When the QSD is positive, the swap is considered to benefit both parties involved.
The quality spread differential is the difference between the two quality spreads. It can be calculated as follows:
- QSD = Fixed-rate debt premium differential - Floating-rate debt premium differential
The fixed-rate debt differential is typically larger than that of the floating-rate debt.
Bond investors can use the quality spread to decide whether higher yields are worth the extra risk.
Interest Rate Swaps
Interest rate swaps trade on institutional market exchanges or through direct agreements between counterparties. They allow one entity to swap their credit risk with another using different types of credit instruments.
A typical interest rate swap will include a fixed rate and a floating rate. A company that seeks to hedge against paying higher rates on its floating-rate bonds in a rising rate environment would swap the floating-rate debt for fixed-rate debt. The counterparty takes the opposite view of the market and believes rates will fall, so it wants the floating-rate debt to pay off its obligations and obtain a profit.
For example, a bank may swap its floating-rate bond debt currently at 6% for a fixed-rate bond debt of 6%. Companies can match debt with varying maturity lengths depending on the swap contract length. Each company agrees to the swap using the instruments it has issued.
Understanding Quality Spreads
A quality spread provides a credit quality measure for both parties involved in an interest rate swap. The quality differential is calculated by subtracting the contracted market rate by the rate available to the counter-party on similar rate instruments.
Real World Example of a Quality Spread Differential
Here's an example of how quality spread differentials work. Company A, swapping its floating-rate debt, will receive a fixed rate. Company B, swapping its fixed-rate debt, will receive a floating rate. The quality spread differential is usually not calculated based on the rates of the instruments used. The creditworthiness of both companies is different.
If Company A (AAA-rated) uses a two-year term floating-rate debt at 6% and Company B (BBB-rated) uses a five-year fixed-rate debt at 6%, then the quality spread differential would need to be calculated based on the rates versus the market rates.
Company A’s 6% rate on the two-year floating-rate debt compares to a 7% rate obtained for Company B on a two-year floating-rate debt, so this quality spread is 1%. For a five-year fixed-rate debt, Company A pays 4% where Company B pays 6%, so the quality spread is 2%. The key is to use similar products in the quality spread calculation in order to compare rates of similar issues.
In the example above, this would be 2% minus 1%, resulting in a QSD of 1%. Remember, a positive quality spread differential indicates a swap is in the interest of both parties because there is a favorable default risk. If the AAA-rated company had a significantly higher floating-rate premium to the lower credit quality company, it would result in a negative quality spread differential. This would likely cause the higher-rated company to seek a higher-rated counterpart.