What is Quality Spread Differential (QSD)

Quality spread differential (QSD) is used to calculate the difference between market interest rates that the two parties potentially entering into an interest rate swap are able to achieve. QSD is a measure companies can use to gauge interest rate swap counterparty default risk.

BREAKING DOWN Quality Spread Differential (QSD)

Quality spread differential is a measure used in interest rate swap analysis. Companies use a quality spread differential to gauge default 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 they think rates will fall so they want the floating rate debt to payoff their obligations and obtain a profit.

As an example, a bank may swap its floating rate bond debt currently at 6% for 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 instruments they have issued.

Quality Spread

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 counterparty on similar rate instruments.

For example, 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.

If Company A (AAA-rated) uses two-year term floating rate debt at 6% and Company B (BBB-rated) uses five-year fixed rate debt at a rate of 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 two-year floating rate debt compares to a 7% rate obtained for Company B on two-year floating rate debt so this quality spread is 1%. For 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.

Quality Spread Differential

The quality spread differential is the difference between the two quality spreads. The quality spread differential is the premium differential on the fixed- rate debt minus the premium differential on the floating-rate debt. In the above example this would be 2% - 1% resulting in 1%. A positive quality spread differential indicates that a swap is in the interest of both parties because there is favorable default risk. If the AAA-rated company had a significantly higher floating rate premium to the lower credit quality company than it would result in a negative quality spread differential and would likely cause the higher rated company to seek a higher rated counterpart.