# Quality Spread Differential (QSD): What it Means, How it Works

## What Is Quality Spread Differential (QSD)?

Quality spread differential (QSD) is used to calculate the difference between market [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) that two parties potentially entering into an [interest rate swap](https://www.investopedia.com/terms/i/interestrateswap.asp) are able to achieve. It is a measurement that companies can use to gauge [counterparty risk](https://www.investopedia.com/terms/c/counterpartyrisk.asp) 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 can use to gauge counterparty risk in an interest rate swap.
*   The QSD is calculated by subtracting the contracted market rate by 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.

## Understanding Quality Spread Differential (QSD)

QSD is a measure used by companies of different creditworthiness in interest rate [swap](https://www.investopedia.com/terms/s/swap.asp) analysis. They use a QSD to gauge [default risk](https://www.investopedia.com/terms/d/defaultrisk.asp). When the QSD is positive, the swap is considered to benefit both parties involved.

A quality spread provides a [credit quality](https://www.investopedia.com/terms/c/creditquality.asp) 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.

The difference between the two quality spreads 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.

> **Tip**
>
> 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](https://www.investopedia.com/terms/c/counterparty.asp). They allow one entity to swap their [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp) with another using different types of credit instruments.

A typical interest rate swap will include a [fixed rate](https://www.investopedia.com/terms/f/fixedinterestrate.asp) and a [floating rate](https://www.investopedia.com/terms/f/floatinginterestrate.asp). A company that seeks to [hedge](https://www.investopedia.com/terms/h/hedge.asp) 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.

## Quality Spread Differential (QSD) Example

Here's an example of how QSDs 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 QSD 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 QSD 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 QSD 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 QSD. This would likely cause the higher-rated company to seek a higher-rated counterpart.