What Is Quality Spread Differential (QSD)?
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. It is a measurement that companies can use to gauge counterparty risk in an interest rate swap.
Key Takeaways
- A quality spread differential (QSD) is the difference between market interest rates achieved by two parties who enter an interest rate swap.
- It is a measurement that companies use to gauge counterparty risk in an interest rate swap.
- The QSD is calculated by subtracting the contracted market rate from the rate available to the counter-party on similar rate instruments.
- When the QSD is positive, the swap is considered to benefit both parties involved.
Delving Deeper into Quality Spread Differential (QSD)
QSD measures the financial health and creditworthiness of companies involved in interest rate swaps. It assists firms in evaluating default risk. When the QSD is positive, it signifies mutual benefits for both parties participating in the swap.
A quality spread acts as a representative metric for the credit quality of both parties. The quality differential is computed by subtracting the contracted market rate from the rate available to the counter-party on similar rate instruments.
The difference between the two quality spreads is calculated as follows:
- QSD = Fixed-rate debt premium differential ‒ Floating-rate debt premium differential
Typically, the fixed-rate debt differential is larger than that of the floating-rate debt. Investors in bonds use the quality spread to discern whether higher yields justify the accompanying risks.
Insights into Interest Rate Swaps
Interest rate swaps are traded on institutional market exchanges or through direct agreements between counterparties. They enable one entity to exchange their credit risk with another using varied credit instruments.
A conventional interest rate swap involves a fixed rate and a floating rate. A company seeking to hedge against rising rates on its floating-rate bonds may swap its floating-rate debt for fixed-rate debt. Conversely, the counterparty believes that rates will decrease, aiming to benefit from floating-rate debt.
For instance, a bank may exchange its floating-rate bond debt currently at 6% for a fixed-rate bond debt of 6%. Companies align debt maturity lengths based on the swap contract. Each agrees to the swap using their issued instruments.
Quality Spread Differential (QSD) in Action
Consider this example to illustrate QSD in action. Company A swaps its floating-rate debt and receives a fixed rate. Meanwhile, Company B exchanges its fixed-rate debt for a floating rate. The creditworthiness of the companies affects the QSD calculation.
If Company A (AAA-rated) uses a two-year term floating-rate debt at 6% while Company B (BBB-rated) uses a five-year fixed-rate debt at 6%, the QSD should be determined based on the comparable market rates.
Company A’s 6% rate on the two-year floating-rate debt can be compared to the 7% rate for Company B’s equivalent. This results in a quality spread of 1%. For a five-year fixed-rate debt, Company A pays 4%, and Company B pays 6%, creating a quality spread of 2%. The key is to compare rates of similar financial products accurately.
In this case, the calculation would be 2% minus 1%, yielding a positive QSD of 1%. A positive QSD implies a favorable swap for both parties, reducing default risk. Conversely, if a higher-rated company experiences a higher floating-rate premium than a lower-rated entity, a negative QSD would emerge, leading the better-rated firm to seek a higher-quality counterpart.
A clear comprehension of QSD can help organizations make more strategic decisions in managing their financial instruments and risk mitigation strategies.
Related Terms: interest rates, interest rate swap, default risk, credit quality
