What it means
Borrowers with different credit ratings pay different interest rates, and the gap between them is called a quality spread. That gap is usually not the same in the fixed-rate market as in the floating-rate market.
The QSD is the difference between those two gaps. The reason this matters is comparative advantage.
A weaker borrower may be penalised more heavily in one market than the other, which means the stronger borrower has a relative edge in the market where the penalty is bigger. Each side borrows where it is relatively cheapest and then swaps payments, and the saving is shared.
The QSD also tells you the maximum total saving available from the swap. If the QSD is 1.00 percentage point, the two parties can between them cut their combined interest cost by 1.00% a year on the notional amount (the sum on which interest is calculated, which is never actually exchanged).
How that saving is divided depends on negotiation, and a bank intermediary usually takes a share. There are practical caveats.
The saving only exists if both parties are creditworthy enough to honour the swap, and the swap itself carries counterparty risk, which is the risk that the other side fails to pay. Some commentators also argue that a persistent QSD is unusual in efficient markets, so a large figure should prompt questions about what risk is being left out.
Finance teams meet the idea when a treasury function wonders whether to fix or float its debt. The QSD gives a quick screen before anyone asks a bank for a formal quotation.
In practice
Real-world examples.
Example
A manufacturer with a strong credit rating wants floating-rate debt, while a smaller supplier wants fixed-rate certainty. A bank notes that the fixed spread between them is much wider than the floating spread, and proposes a swap that lets each borrow in the market where it is relatively cheaper.
Example
A property developer compares quotes from lenders and finds the fixed-rate premium for its weaker credit is 1.20 percentage points while the floating premium is only 0.40. The 0.80 percentage point QSD tells its treasurer that a swap is worth pursuing.
Example
An analyst in a bank structuring team uses QSD to decide whether a pair of clients is worth matching. When the figure is close to zero she drops the idea, because the cost of arranging the swap would eat the whole saving.
Formula
Calculation
QSD = (fixed-rate spread between the two borrowers) - (floating-rate spread between the two borrowers)
Annual saving available = QSD x notional amount
Suppose Company A can borrow at a fixed 5.00% or at a floating benchmark rate plus 0.20%. Company B can borrow at a fixed 6.50% or at the floating benchmark plus 0.70%. The fixed-rate spread is 6.50% - 5.00% = 1.50%, and the floating-rate spread is 0.70% - 0.20% = 0.50%. The QSD is 1.50% - 0.50% = 1.00%. On a notional amount of $10,000,000, the total annual saving available is 10,000,000 x 1.00% = $100,000, which the two companies and any intermediary would share.Case study
Seen in the real world.
Brightwater Logistics is an illustrative, fictional freight company with a strong credit rating that preferred floating-rate borrowing. Its counterpart, Tidewell Packaging, a fictional smaller business, wanted the certainty of a fixed rate but paid a heavy premium for it.
Brightwater could borrow fixed at 4.80% or floating at the benchmark plus 0.25%, while Tidewell faced 6.30% fixed or the benchmark plus 0.75% floating. The QSD was therefore (6.30% - 4.80%) - (0.75% - 0.25%), which equals 1.00%.
On an illustrative $5,000,000 notional amount the shared annual saving was $50,000, and the bank arranging the swap kept $10,000 of it as its fee. The lesson is that the QSD pointed out the opportunity, but the net benefit to each company depended on the intermediary's share and on the risk that the other side might default.
Watch out
Common mistakes.
- Reading the QSD as a guaranteed profit, when it is only the maximum gross saving before the bank's fee and before any allowance for counterparty risk.
- Subtracting the spreads in the wrong order, which gives a negative number and hides the opportunity.
- Assuming the saving is split equally, when the split is negotiated and depends on bargaining power and the intermediary's margin.
Questions
People also ask.
What does a QSD of zero mean?
It means the weaker borrower pays the same premium in both markets, so there is no comparative advantage and no gain from swapping.
Why do the spreads differ between markets?
Lenders price credit risk differently over fixed and floating terms, because a longer fixed commitment exposes them to more uncertainty about a weaker borrower.
Is QSD the same as the credit spread?
No, a credit spread is a single borrower's premium over a benchmark, while the QSD compares two spreads across two markets.
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