For businesses offering services and contracts in a supply chain to other businesses, effective balancing of short and long term costs and income is a common challenge. When these businesses need to provide financial assurance in advance of supplying a contract to another business, surety bonds are a popular and more flexible alternative to bank guarantees.
Fundamentally security bonds provide financial assurance against non-performance or default of a contracted service. They are especially valuable in business conditions and industries where uncertainty is a key risk factor.
Frequently used in the construction, infrastructure, resources, energy, renewables and manufacturing sectors, surety bonds provide the business taking out ‘surety’ with the ability to provide financial assurance to the purchaser of their supply services, without tying up valuable working capital and having to provide securities. A surety bond is essentially short-term, temporary form of credit and therefore does not breach any banking covenants.
Often businesses have the capability but not the balance sheet strength to tender on larger contracts because they don’t have sufficient working capital to put up the securities required for the contract values. Surety bonds can provide business suppliers with the financial flexibility to reinvest working capital, reduce debt or tender on additional projects, as they are not required to lock in other assets or capital as security.
Examples of surety bond uses include
- a construction business building a project according to contract specifications
- a business supplying goods to a customer within a predetermined time frame.
If the contracted work is not carried out according to the agreed terms the employing client can claim on the surety bond to pay for the shortfall or a penalty. The surety issuer can then claim reimbursement from the business that defaulted on the contract.
“A surety bond is an unconditional on-demand financial instrument which is widely accepted by principals, the main benefit being it can free up a company’s working capital, which can be instrumental in supporting their growth and ability to tender on larger contracts.”
Racheal Tumelty, National Head of Trade Credit, Surety & Political Risks
Situations where surety bonds are commonly used
Surety bonds are required by state regulatory agencies for some types of businesses to operate locally and also guarantee that contractors will complete construction projects in accordance with specifications and make all required payments to subcontractors and suppliers.
Two types of bonds are in involved: commercial surety bonds ensure a business complies with applicable regulations, while contract surety bonds provide a financial guarantee for construction projects.
Commercial surety bonds satisfy the security requirements of public, legal and government entities and protect against financial risk by guaranteeing that the business or individual will comply with all required legal obligations. They can apply to public officials, legal executors, employment agencies and property developers, to name a few examples. They are particularly useful to new or unknown businesses as an assurance of the legitimacy of their work.
Contract surety bonds are used primarily in the construction industry. These bonds protect the procuring business from financial loss in the event that the contractor fails to fulfil the terms and conditions of their contract, safeguarding against the suppliers inability to complete a job or pay related debts. Contractors engaged in both government and private sector work may be required to hold contract surety bonds by the project issuers. Contract bonds involved could cover bids, sub-contractor or supplier payments and future maintenance obligations.
How surety bonds work as financial guarantees
Commercial surety and contract surety bonds provide a line of credit that acts a financial guarantee. These bonds always involves three parties
the obligee who receives payment if the terms of the surety contract are defaulted
the principal who bears the contracted obligation, such as the contracted business supplier
the surety, the insurance company issuing the bond, which assumes the financial aspect of the obligation but can seek reimbursement from the principal.
Large businesses or companies often utilise surety bonds as a risk strategy because they are seen as one of the most one the most cost-effective ways to finance contract security obligations”. The advantages include that unlike a bank, surety providers do not require security over your company’s assets or for bonds to be supported by cash or other collateral.
Surety bond premiums are charged on usage only and there are no renewal fees. They remain valid for the period of the contract involved and sometimes for an extended maintenance period covering the time during which problems might manifest.
As an example, in early 2018 Peabody Energy secured nearly $150 million of surety bonds through the local insurance market to pay down debt and invest in extensions to its coal mining operations in Queensland and New South Wales, the Australian Financial Review reported.
Under the agreement the insurers guaranteed to pay government regulators a proportion of any shortfall in contracted works while charging Peabody a commercial rate for taking on the risk, enabling the energy company to retain working capital to expand its operations.
Surety bond providers and terms
Bond providers in Australia are Standard & Poor’s (S&P) rated A and up to AA+, Australian Prudential Regulation Authority (APRA) approved and comparable in terms of financial scale to the four major banks, if not better with certain sureties, Tumelty says.
Like bank guarantees, surety bonds are unconditional and on demand, and are widely accepted in the Australian market by federal, state and local governments, and public and private enterprises.
The typical qualifying criteria surety providers require includes annual revenue of $50m and above, a net equity position of $5m and above, a trading history of more than 3 years with a minimum of 2 consecutive years’ profitability. Personal guarantees from directors are also required for private companies with turnover of less than $300m.
“Surety bonds carry an identical wording to bank guarantees and follow the Australian standard AS2124 wording, which is an unconditional and on demand undertaking, Tumelty says. “Surety bonds carry exactly the same obligations at law as a bank guarantee.”
Usually 5‒10% of total contract value is required by security bond providers as security, but not necessarily as cash backing or tangible security, unlike banks which require 100% cash collateral or a general security agreement (GSA) or other property assets from the applicant business to secure a bank guarantee.
Interested in finding out more about obtaining surety bonds?
We have the expertise and relationships with surety bond providers to support business that are seeking an alternative to bank guarantees and retention monies, both of which tie up working capital.
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