Leverage surety bonds over letters of credit
The economy is in a continual state of flux, with interest rates, inflation, employment trends, consumer behaviors, government policies, and global markets shaping its health and trajectory. As organizations respond to evolving economic conditions, embracing innovative solutions and strategies can help them optimize cash flow and safeguard against financial risks, especially during times of economic uncertainty.
Companies that need to guarantee a variety of financial and performance obligations may be considering surety bonds or letters of credit. Though these aren’t novel financial instruments, more companies are now utilizing surety bonds over letters of credit. Additionally, because of the economic instability of recent years and several notable bank failures, surety bonds are more often being accepted in lieu of letters of credit.
While both a surety bond and a letter of credit offer sound financial protection, surety bonds have many key financial advantages over letters of credit, as we detail below.
How are surety bonds and letters of credit similar?
A surety bond and letter of credit act as a promissory note that that guarantees payment to a third party, and they’re used in business transactions to build trust and protect parties from losses.
Both serve as an agreement between three different parties:
Surety bond
- Surety – the bond provider guaranteeing the principal’s performance
- Principal – the entity with an obligation to perform
- Obligee – the beneficiary of the bond
Letter of credit
- Issuing bank – the financial institution that issues the letter of credit
- Applicant – the entity that requests the letter of credit
- Beneficiary – the entity that receives payment
What are key differences between a surety bond and letter of credit?
There are several important differences between surety bonds and letters of credit that you should consider as you’re weighing your options.
| Key difference | Surety bonds | Letters of credit |
|---|---|---|
| Purpose | Guarantees performance or compliance with contractual obligations | Guarantees payment to the beneficiary upon demand or compliance with terms |
| Credit impact | Does not affect the company’s bank credit lines, providing greater liquidity and financial flexibility | Ties up credit capacity since they’re issued against the company’s available credit line, reducing borrowing power |
| Cost | Typically lower premiums, tied to credit quality and obligation type. | Higher costs, including issuance, commitment, and utilization fees. |
| Collateral requirements | Rarely requires full collateral, but requires the principal demonstrate financial stability; often unsecured with no UCC filings | Often requires 100% collateral, such as cash or assets, encumbering liquidity; typically perfected with UCC filing |
| Covenants | Generally no restrictive covenants or financial ratio requirements. | May impose restrictive covenants, such as maintaining specific financial metrics. |
| Claims process | Surety investigates claims to validate default before paying bond, offering defenses for the principal | Pays funds out to beneficiaries immediately on demand, without investigating default |
| Speed of payment | Beneficiary must prove default before payment is made | Immediate payout upon compliant documentation |
| Sector stability | Backed by the insurance/surety sector, which is typically more stable | Subject to unpredictability of the banking sector |
| Flexibility | Provides flexibility by preserving liquidity and working capital | Restricts flexibility due to tied-up collateral and reduced credit capacity |
| Acceptance | Ideal for performance and compliance obligations; growing acceptance across industries. | Preferred for payment guarantees and immediate access to funds; standard in international transactions |
| Indemnity risk | Principal indemnifies the surety for losses incurred on claims | No indemnity risk for the applicant, as the bank honors the beneficiary’s draw request unconditionally |
When is a letter of credit a better option?
Depending on the specific requirements of the transaction, the parties involved, and the nature of the risk being guaranteed, in some instances, letters of credit might be more adequate.
Letters of credit are a viable option in the following situations:
- Guarantee payment certainty
- Ensure immediate access to funds
- Meet beneficiary requirements
- Fulfill specific regulatory obligations
- Businesses with high cash reserves
- Creating more personalized terms
- International trade and foreign transactions
However, for most situations, there are significantly more benefits to using a surety bond.
Why is a surety bond more beneficial?
For businesses, surety bonds are often more beneficial than letters of credit. The shift toward surety bonds reflects several key advantages:
- Credit capacity –Letters of credit tie up the company’s credit capacity, thus reducing financial flexibility. Bonds do not encumber credit lines or require full collateral, preserving working capital for other uses.
- Covenants – Letters of credit often include restrictive covenants imposed by the issuing bank, such as requirements to maintain minimum liquidity, net worth, or debt-to-equity ratios, potentially limiting a company’s other operations. Surety companies typically impose fewer or no restrictive covenants. Their primary concern is the financial stability and performance history of the company at the time of underwriting.
- Security – Letters of credit are usually fully secured by cash collateral or other assets and are perfected through public UCC filings. This means the issuing bank holds a priority claim on the company’s assets. Sureties are generally unsecured creditors, and UCC filings are rarely made.
- Default defenses – Letters of credit are demand instruments that may be drawn down at any time, without proving the company has defaulted, leaving the company with no recourse to dispute the claim before funds are withdrawn. With surety bonds, surety carriers have dedicated claim staffs and require proof of default to determine claim validity and work to identify defenses for the company prior to bond proceeds being paid.
- Rates – Letters of credit may include a commitment fee or utilization fee, as well as issuance fees, in addition to a stated rate. Surety bond rates tend to be more stable and are directly tied to the credit quality of the company and to the types of obligations bonded. For well-qualified businesses, bond premiums are often lower than letter of credit fees, making them a more cost-effective solution in the long run.
- Stability – The insurance and surety sectors are perceived as more stable than the banking sector, increasing confidence in bonds as a reliable financial instrument.
These advantages make surety bonds especially appealing in industries requiring performance guarantees, compliance with regulations, or protection against contractual risks.
Surety bond use cases
We’re seeing many organizations leverage surety bonds for obligations including, but not limited to:
- High deductible self-insured insurance programs – For self-insured programs like workers’ compensation, general liability, or auto liability, bonds are increasingly used to secure high deductible obligations. Insurers and regulators often require financial guarantees to ensure claims are paid, even if the insured party faces financial difficulties.
- Court decisions (security for appeals) – When appealing court decisions, litigants may need to post a bond or letter of credit to secure the judgment amount and demonstrate their ability to pay if the appeal is unsuccessful. Surety appeal bonds are now becoming a preferred option.
- Performance and financial obligations (leases, utility deposits, etc.) – In these cases, a bond guarantees the fulfillment of contractual terms, with landlords and utility providers becoming more open to bonds as they recognize their reliability and cost-efficiency.
- International performance and financial obligations – In international markets, letters of credit have traditionally been used to secure performance and financial obligations, often requiring 10 percent of the contract value to be held in reserve. However, the growing acceptance of bonds in these scenarios is driven by their ability to provide the same guarantee without requiring upfront collateral.
As bonds gain broader acceptance across industries and international markets, they provide businesses with a versatile and cost-effective alternative to letters of credit for securing financial and performance obligations.
Embrace the benefits of surety bonds
If you’re interested in exploring the benefits of surety bonds for your organization, The Baldwin Group’s Surety Center of Excellence can determine which solutions align with your business needs, providing you guidance and education to help you make informed decisions aligned with your goals.
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This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The content of this document is made available on an “as is” basis, without warranty of any kind. The Baldwin Insurance Group Holdings, LLC (“The Baldwin Group”), its affiliates, and subsidiaries do not guarantee that this information is, or can be relied on for, compliance with any law or regulation, assurance against preventable losses, or freedom from legal liability. This publication is not intended to be legal, underwriting, or any other type of professional advice. The Baldwin Group does not guarantee any particular outcome and makes no commitment to update any information herein or remove any items that are no longer accurate or complete. Furthermore, The Baldwin Group does not assume any liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Persons requiring advice should always consult an independent adviser.
