Construction bonds: managing risks

Your word is your bond

29 April 2019

With a more detailed understanding of construction bonds, practitioners can manage risks for all parties involved in a project

Construction bonds, or surety bonds, are security instruments that mitigate risk for clients, developers, contractors and their supply chains. They are formal agreements involving 3 parties:

  • the surety: usually a bank or insurance firm;
  • the project owner, beneficiary or client: the named beneficiary;
  • the principal or performer: normally contractors, consultants, subcontractors and suppliers.

The surety guarantees to make a predetermined payment to the project owner or client should the principal fail to perform or fulfil their contractual obligations (see Figure 1).

Figure 1: The key parties involved in construction bonds and their respective relationships

Figure 1: The key parties involved in construction bonds and their respective relationships (Source: ALPHAQS)

Surety bonds broadly fall into 2 categories: conditional, and on-demand.

Conditional bonds

The beneficiary has to prove that the principal has failed to meet their contractual obligations, and as a direct result they themselves have incurred financial losses. Some conditional bonds will only be honoured if all of the conditions are met; most beneficiaries are therefore reluctant to accept some conditional bonds, and often ask the legal teams involved to revise the terms to be more equitable.

Conditional bonds typically take the form of a retention bond, which is issued by the surety to a specified client to guarantee and pay an agreed sum in the event of non-performance or principal insolvency. This improves the principal’s liquidity, and safeguards retention payments to the supply chain should it become insolvent.

On-demand bonds

With these bonds, the beneficiary simply has to submit the bond and demand payment from the surety. It is not obliged to provide any evidence that the principal has breached or failed to fulfil its contractual obligations, so most principals are therefore reluctant to sign up to terms and conditions with on-demand clauses.

On-demand bonds typically take one of the following forms.

  • Bid bond: this is issued by the surety to guarantee that a bidder will enter into a formal contract if its bid offer is accepted. If not, the surety will pay the client the sum mentioned in the bond. Such a bond is normally applied to cost- and schedule-sensitive bids, and ensures only committed tenderers participate in the process.
  • Advance payment bond: at times clients issue advance payments to suppliers and service providers, and this bond will safeguard these in the event of the non-performance or insolvency of either. The bond helps minimise risks associated with inflation, securing fixed commodity prices during hyperinflation, as well as risks associated with currency movements for materials procured from abroad, and helps the principal to accelerate service provision.
  • Payment bond: the surety guarantees to reimburse an agreed sum to the client in the event of performance failure or the principal’s insolvency. It is ideal for helping principals to accelerate progress on a project, as well as reducing the client’s financial risk.
  • Roads and drainage bond: principals – usually developers – take out a bond in favour of the client – often local authorities – that guarantees a prescribed sum be paid in the event of a failure to hand over roads and drainage services in a condition that fulfils Building Regulations. The bond lowers the client’s financial risk exposure.
  • Off-site materials bond: this is issued to guarantee payments made to the principal for off-site materials, commonly when a substantial portion of the work has to be completed off site and the beneficiary needs to minimise exposure to financial risk if the principal or supplier falls into liquidation. The off-site materials have to be handled as the conditions in the bond agreement specify.

Alternatives and variations

We have recently witnessed the emergence of a third category of bonds that is yet to gain a formal nomenclature, but which share traits of both conditional and on-demand bonds. As construction procurement models keep evolving and now tend to prefer collaborative approaches, we are likely to see more such forms dominate bond markets as their terms and conditions are often equitable and more palatable for beneficiaries and principals alike.

As construction procurement models continue to evolve we are likely to see more hybrid forms of bond dominate the markets

These bonds typically take the form of a performance bond, which is issued by the surety to guarantee performance by the named principal. In the event of performance failure, the named client will be paid the prescribed amount, usually 10% of the contract sum. This reduces the client’s financial risk as it is able to fund the cost to replace the principal with the bond payment.

Different forms of contract also have different provisions for construction bonds, as some examples from the UK demonstrate.

  • JCT: the contract particulars contain provisions for using performance, retention, advance payment and bid bonds. These particulars are drafted by the beneficiary, so tend to be on-demand bonds. The principal’s failure to produce the specified bond is deemed a serious breach and may lead to contractual termination.
  • NEC: secondary option clauses for bonds under this form of contract are the X13 performance bond, X14 advance payment bond and X16 retention bond. Bond conditions are specified in the works information section of the contract; failure to provide the bond on the project manager’s instruction will lead to the withholding of a quarter of payment due and, eventually, to contractual termination.
  • ICC: these conditions require the contractor or supplier to provide performance security bonds under clause 18. The bond specifications are outlined in the appendix and the form of bond annexed to the conditions of contract. Provision of the bond is deemed a condition precedent to any obligation the employer has to make payments that might otherwise be due under this contract.

Bond wordings and forms are mostly set by the Association of British Insurers. Internationally, FIDIC is the contract form used on most major World Bank projects. It recommends the use of construction bonds when contracting suppliers and contractors, but discourages the use of surety bonds when appointing consultants.

Bond costs

Costs are determined by many factors, key among which is the financial status of the performer or principal taking out the bond: firms with strong balance sheets and high credit ratings will secure bonds at lower costs than peers with weaker balance sheets and lower credit scores. The cost of surety bonds is also determined by the risk levels associated with:

  • the nature and type of the task or contract
  • the performer or principal’s performance record
  • the industry or sector
  • the general economic climate and forecasts.

Bond costs are therefore difficult to estimate. In the UK they tend to vary between 1.5 and 8% of the bond value, with a flat fee ranging from £700 to £1,500. In some circumstances, performers and service providers tend to be reluctant to issue bonds as the full bond value is marked against their overdraft facility, which can have a detrimental effect on their balance sheet and credit score ratings.

Surety bonds, when correctly understood and used, are tools that can effectively mitigate financial risk for clients and supply chains.

Elliot Patsanza FRICS is director, head of infrastructure cost and management services at Capita Real Estate and Infrastructure

Further information

Download a complete “Construction bonds: managing risks” PDF