When project owners or obligees require financial assurance that a contractor (the principal) will fulfill its obligations—or that other statutory or development-related requirements will be met—they often consider two principal instruments: surety bonds and irrevocable letters of credit (ILOCs). While both serve to protect obligees from financial loss, surety bonds (including performance and payment bonds) frequently offer advantages for both the principal and the obligee. Below, we explore key factors—borrowing capacity, prequalification, duration/renewal (and owner draw rights), automatic coverage adjustments, broader bond applications, cost, claims handling, and mutual benefits—to illustrate why bonds can be preferable to ILOCs.

1. Surety Bonds vs. ILOCs: A High-Level Comparison

Surety Bonds are three-party arrangements among a surety (typically an insurer), a principal (contractor or bond applicant), and an obligee (project owner or party requiring compliance). In construction, a performance bond guarantees completion per contract terms, and a payment bond secures payment to subcontractors and suppliers if the principal defaults. Outside construction, surety bonds also fulfill statutory obligations (e.g., license-and-permit bonds, probate bonds) and support development projects (e.g., performance bonds for infrastructure undertakings). If the principal fails, the surety can finance completion, appoint a replacement contractor, or pay up to the bond’s penal sum to satisfy claims.

Irrevocable Letters of Credit (ILOCs) are two-party instruments issued by a bank on behalf of the principal, guaranteeing to pay the obligee a specified amount on demand, typically up to a preset limit (often 5–10% of contract value in construction settings). Once invoked, the bank pays immediately, and the principal’s obligation to the bank converts to debt. Unlike bonds, ILOCs do not involve an underwriting assessment of project performance—they simply provide liquidity when drawn upon.

2. Borrowing Capacity: Preserving Liquid Assets vs. Pledging Collateral

A cornerstone advantage of surety bonds is the minimal impact on a principal’s borrowing capacity. As part of underwriting, the surety evaluates the principal’s financial strength, operations, and track record—usually without demanding specific collateral. Because no liquid assets are set aside, a bonded principal retains full use of working capital, equipment financing, and existing credit lines. In many cases, bonding can even enhance a contractor’s financial profile, signaling to lenders that an experienced surety has vetted and approved the operation.

By contrast, securing an ILOC typically requires setting aside—or pledging—cash, certificates of deposit, or other high-quality collateral equal to the ILOC amount. These funds then cannot be used for daily operations, payroll, or equipment purchases. Moreover, since an outstanding ILOC shows as a contingent liability, it effectively reduces the principal’s available borrowing capacity with banks and can complicate other financing arrangements.

3. Prequalification: Rigorous Vetting vs. Collateral Focus

Surety underwriting is a proactive, three-pronged analysis encompassing (1) financial strength and liquidity (capital), (2) operational capacity (including workload, management, and reputation), and (3) experience and character. That in-depth review encourages principals to maintain sound practices, while giving obligees confidence that a bonded contractor is truly capable of completing its obligations. If the underwriting reveals unacceptable risk, the surety can decline issuance, effectively steering the obligee away from underqualified principals.

Conversely, banks issuing ILOCs largely concentrate on collateral quality and principal creditworthiness. If the pledged assets meet required haircuts, and the principal’s overall balance sheet appears sufficient, the bank will issue the ILOC—regardless of whether the principal has the specific expertise or track record to complete the contract. This forces the obligee to perform its own due diligence on the principal’s capabilities, adding time and an administrative burden.

4. Duration, Renewal, and Owner Draw Rights

Generally, a surety bond’s term aligns with the contract lifecycle—including any maintenance or warranty periods. Once issued, performance and payment bonds remain in effect until final acceptance, plus any agreed-upon post-completion coverage, without annual renewals. This seamless coverage ensures continuous protection, and neither principal nor obligee risk a lapse (absent special circumstances).

By contrast, ILOCs are typically issued for fixed terms—often one year—with automatic “evergreen” provisions that renew unless canceled. While renewing an ILOC may be straightforward for a healthy principal, each renewal often entails bank fees and potential re-qualification. If the principal’s credit profile weakens, the bank could demand additional collateral, refuse renewal, or replace the ILOC with a standby letter, creating uncertainty for the obligee. Furthermore, an obligee may draw on an ILOC at any time before expiration (subject to terms)—a “on-demand” feature that offers liquidity but may also diminish the collateral pool and reveal operational distress.

5. Automatic Coverage Adjustments for Contract Price Increases

In long-running or change-order–intensive projects, contract prices often rise as additional work is added. Certain surety bonds include “increased penal sum” provisions: if the underlying contract is amended (subject to surety consent and bond conditions), the bond’s coverage can automatically adjust to match the updated contract price, up to the performance bond’s maximum penal sum. This flexibility allows principals to pursue change orders without renegotiating collateral, and obligees remain fully protected as the project scope grows.

By contrast, an ILOC’s face value typically remains fixed unless the principal negotiates an amendment with the issuing bank—often a time-consuming process that requires additional collateral or higher fees. Consequently, obligors can find themselves under-collateralized if the contract value outpaces the ILOC, exposing the obligee to uncovered shortfalls.

6. Other Types of Bonds Beyond Construction

While performance and payment bonds dominate in the construction realm, surety bonds appear in many other contexts:

• Statutory License & Permit Bonds: Governments require these bonds to guarantee compliance with licensing laws for contractors, mortgage brokers, auto dealers, and other regulated professions. If the licensee violates statutes or regulations, claimants can submit bond claims for restitution.
• Court Bonds (Judicial Surety): These ensure one party’s financial obligations in litigation settings, e.g., appeal bonds, fiduciary bonds, and attachment bonds—so that plaintiffs and fiduciaries comply with court judgments or fiduciary duties.
• Development & Infrastructure Bonds: Beyond simple performance, developers may secure bonds guaranteeing completion of utility, road, or environmental restoration work—ensuring public interests remain protected even if the developer defaults.

In each scenario, the three-party framework and underwriting focus remain constant, granting sureties—and, by extension, obligees—the confidence that principals meet defined financial and operational benchmarks before obtaining coverage.

7. Benefits for Both Bond Principals and Obligees

Surety bonds deliver symbiotic advantages:

1. For Bond Principals
   • Enhanced Credit Profile: A bond signals to owners and lenders that a reputable surety has vetted the principal’s capabilities, potentially unlocking new opportunities and negotiated terms.
   • Preserved Working Capital: Since no collateral pledge is normally required, principals maintain full liquidity to run operations, staff projects, and invest in growth.
   • Automatic Bond Adjustments: As described earlier, the principal can pursue necessary contract changes without renegotiating collateral or bond terms in most circumstances.
   • Competitive Edge: Owners often prefer bonded contractors, particularly on large or public projects; thus, having a bond can be a critical differentiator during bid evaluation.
2. For Obligees (Project Owners, Government Entities, and Other Beneficiaries)
   • Assured Performance Oversight: The surety’s vetting means the obligee can focus on project success rather than micromanaging contractor due diligence.
   • Active Claims and Completion Remedies: If the principal defaults, the surety may finance, take over, or arrange a new contractor—helping to minimize delays and cost overruns.
   • Statutory and Regulatory Compliance: In bonded licenses or permits, claimants (e.g., consumers, subcontractors) have a direct mechanism for restitution without complex litigation.
   • Broad Applicability: From construction to regulatory bonds, the obligee benefits from a consistent claims process and dispute resolution timeline, rather than negotiating ad hoc collateral draws.

8. Cost Comparison: Upfront Premiums vs. Ongoing Fees and Collateral Demands

Securing a surety bond typically carries a one-time premium, usually spanning 0.5% to 3% of the contract value, depending primarily on the principal’s credit, project complexity, and any supporting government bond guarantee programs. Since the premium is calculated at bid—and often built into project overhead—the principal faces no immediate collateral requirement, and the obligee pays no direct bond fees.

In contrast, an ILOC fee generally approximates 1% per year of the secured amount. As contract values rise, the required amount (and thus the annual fee) often increases. Should the ILOC need extension, renewal fees can add to the cost. Additionally, because collateral is already pledged, the principal effectively incurs an opportunity cost—the inability to deploy that collateral elsewhere—and potentially pays additional bank charges for collateral maintenance.

9. Claims Handling: Proactive Project Oversight vs. Passive Drawdown

When a principal defaults under a performance bond, the surety takes an active role:

1. Investigate the default and verify its validity.
2. Finance the existing prime contractor so work continues uninterrupted.
3. Take Over the project—engaging the obligee in selecting qualified replacement contractors.
4. Tender a new principal to complete the contract, leveraging the surety’s network.
5. Pay the obligee up to the bond’s penal sum to finish project obligations.
   Moreover, payment bonds ensure that valid claims from subcontractors and suppliers are paid directly by the surety, preventing mechanics’ liens and preserving project cash flow.

By contrast, when an obligee presents an ILOC, the bank pays the face amount on demand—without any inquiry into project status or claim validity (subject to documentary requirements). Once funded, the obligee must solve the downstream puzzle: arranging a replacement principal, negotiating subcontractor claims, or allocating funds, all without the surety’s operational support. This can exacerbate delays and administrative burdens during an already stressful default scenario.

10. Conclusion: Why Many Principals and Obligees Prefer Bonds Over ILOCs

While ILOCs can offer quick liquidity, they often transfer the burden of project completion and claimant resolution entirely onto the obligee—along with tying up substantial collateral for the principal. Surety bonds, by contrast, blend proactive underwriting, minimal collateral demand, alignment with contract lifecycle, automatic adjustment for price changes, and an active commitment to project completion. These features benefit both the principal (through preserved borrowing capacity, competitive advantage, and operational flexibility) and the obligee (through rigorous vetting, hands-on claims resolution, and continuous coverage).

Whether in construction, statutory licensing, judicial proceedings, or development projects, surety bonds remain a versatile, cost-effective instrument that aligns incentives across all parties. For principals seeking growth without collateral strain—and for obligees demanding surety-backed performance and payment assurances—bonds often represent the superior solution compared to ILOCs. 

The content of this blog post is provided solely for informational purposes and does not reflect the underwriting guidelines, policies, or views of Lexington National Insurance Corporation. Readers should not construe any discussion here as binding or as professional advice; for guidance specific to your circumstances, please consult a qualified surety underwriter, legal advisor, or other professional.