Surety Guarantees vs Standby Letters of Credit: Why Businesses Prefer Surety

A company that must post USD 25 million of security has several options. It could place USD 25 million into escrow, ask its bank to issue a standby letter of credit, or arrange an acceptable surety guarantee.

The beneficiary may obtain security under all three structures. For the company posting that security, however, the liquidity consequences can be very different.

Why an SBLC Can Tie Up More Capital

A standby letter of credit substitutes the issuing bank's credit for that of its customer. As J.P. Morgan explains, the bank undertakes to pay the beneficiary if the conditions of the standby are satisfied.

From the bank's perspective, that is credit exposure. The bank is effectively placing its balance sheet behind the applicant.

Depending on the applicant's credit quality, an SBLC can therefore require:

This does not mean every SBLC is 100% cash collateralized. Strong investment-grade companies may obtain substantial unsecured LC capacity. The important point is that the instrument normally consumes bank credit capacity even when cash is not deposited dollar for dollar.

Surety Creates Another Pool of Credit Capacity

A surety arrangement introduces a different provider of contingent credit, usually an insurance company or specialist surety.

The Surety & Fidelity Association of America describes a surety bond as a three-party arrangement between the principal, the surety and the beneficiary, or obligee. The surety guarantees the principal's performance or payment obligation.

Crucially, the surety facility normally sits outside the borrower's bank revolver. This allows a company to preserve bank capacity for working capital, acquisitions, construction loans and other funded debt.

Surety Guarantee vs SBLC

Example: USD 50 Million Guarantee Requirement

Assume an infrastructure developer has a USD 200 million revolving facility and must provide a USD 50 million performance guarantee.

The example is simplified, but it captures why treasury teams pay attention to surety. The company has obtained USD 50 million of contingent support without necessarily sacrificing USD 50 million of borrowing availability at its relationship banks.

Aon: The Objective Is to Unlock Working Capital

Aon specifically identifies this treasury issue. It notes that bank guarantees and letters of credit can effectively tie up funds corresponding to the guarantee requirement, while an unsecured surety facility may avoid tying up equivalent funds.

Marsh: Replace LC Capacity With Surety Capacity

Marsh describes letter-of-credit replacement surety as a way for companies to free banking lines for core working-capital requirements. Marsh also notes that surety markets can provide additional guarantee capacity separately from conventional banking facilities.

The Surety Still Underwrites the Company

Surety is not free money and it is not risk transfer for the principal.

If the surety pays a valid claim, it will generally seek reimbursement from the principal under an indemnity agreement. The surety therefore underwrites the company's ability to perform the underlying obligation and reimburse the surety if necessary.

Underwriters can examine:

Weaker credits may still be asked to provide collateral. The liquidity advantage of surety therefore depends on underwriting rather than simply choosing a different instrument.

Surety Can Also Be More Flexible for Performance Obligations

An SBLC is principally a payment mechanism. If the beneficiary presents complying documents, the issuing bank pays according to the terms of the credit.

Traditional performance surety can provide a broader response. Depending on the bond and governing law, the surety may investigate a default, finance the existing contractor, arrange replacement performance, tender a replacement contractor or satisfy its monetary obligation under the bond. This distinction is particularly relevant in construction and infrastructure projects where completing the asset may matter more than simply receiving cash.

Why Would a Beneficiary Still Ask for an SBLC?

The advantages of surety do not mean it is always preferable to the beneficiary.

An SBLC can be attractive because:

J.P. Morgan describes the SBLC as an instrument under which the issuing bank's financial strength is substituted for that of its customer. That simplicity is one reason lenders, utilities, landlords and commercial counterparties frequently request bank paper.

Not Every Surety Guarantee Is On Demand

This is one of the most important distinctions when comparing the instruments.

A traditional conditional surety bond may require evidence of default before the surety's obligation crystallizes. An on-demand surety guarantee can be drafted much closer to the economics of a bank guarantee or SBLC. Marsh notes that some surety markets now provide full on-demand guarantees specifically designed as LC replacements.

Pros and Cons

The Treasury Question Is Bigger Than the Guarantee Fee

Companies sometimes compare an SBLC fee with a surety premium and choose the lower headline price. That can miss the economic issue.

Suppose an SBLC costs 1.00% per year and a surety guarantee costs 1.25%. The SBLC appears cheaper.

But if the SBLC also absorbs USD 50 million of revolving-credit availability that the company could otherwise use for inventory, acquisitions, construction or working capital, the additional 25 basis points for surety may be economically insignificant relative to the liquidity preserved.

Where Surety Replacement Works Particularly Well

Businesses increasingly examine surety alternatives for:

Aon has highlighted the use of surety in acquisition and renewable-energy transactions specifically because replacing bank LCs can release capital for other purposes.

For Large Projects, the Best Structure Can Use Both

The choice is not always binary.

A company may reserve bank LC capacity for beneficiaries that insist on bank paper while transferring performance bonds, utility guarantees, environmental obligations and other eligible exposures into the surety market. This creates two sources of contingent credit rather than forcing every guarantee through one banking syndicate.

Guarantee availability, collateral requirements, pricing and beneficiary acceptance depend on the applicant, underlying obligation, jurisdiction, wording, tenor and provider underwriting. Financely is not a bank, insurer or surety company and does not itself issue guarantees or letters of credit.