The Surety Bond Market has Evolved

Here at Rorwenger, we talk all about bonds.  However, there are specialized types of bonds out there that we don’t always hit on.  One of those types of bonds are surety bonds.

What are Surety Bonds?

Surety bonds are three party contracts.  What happens is that one party, called a surety, provides a guarantee for another party.  However, unlike a traditional guarantee, the surety is actually a party to the original agreement.  Thus, if there is a problem with the contract, the surety is a party to that contract and must step into the shoes of the party being guaranteed.

How Do these bonds work?

Let’s take a look at a performance bond in a construction contract.  Let’s assume that a general contractor has won a bid to build a strip mall on a piece of vacant land.  The land owner has the contractor get a surety, like AIG or Zurich, to guarantee that work.  If the contractor is unable to finish the work, then AIG or Zurich would have to find another contractor to finish the work per the terms of the contract.  Then, AIG would try to collect their expenses from the original contractor.

performance bond

How are these surety agreements evolving?

Given the financial distress that has occurred over the past decade, many firms are trying to reduce the amount of unseen risk that they incur.  One of the big ways to do that is to require a surety bond in all sorts of areas that they traditionally were not required.  For example, a contractor surety bond would have been required for any governmental job per the Miller Act.

But we’ve seen the same types of bonds being required by private parties in the regular course of business.

What’s the practical effect?

The biggest effect is that this course of business helps facilitate other financing.  By reducing the risk (whether real or perceived), the financing alternatives are much greater.  So, we’re seeing that small, specialized types of agreements are helping to create a system where the overall finance can move forward.

Life sure is interesting, isn’t it?

Money and Markets

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