International surety bonds vs letters of credit: A brief introduction
Not sure what the difference between international surety bonds and letters of credit is, or which might be right for you? Read our brief introduction.
Among the many challenges facing businesses today is selecting the best means of guaranteeing their obligations to customer and agencies alike.
Traditionally, a specific insurance policy might have suffice, but acquiring insurance can be a pricey, difficult process, which is why businesses today are considering better options such as letters of credit and surety bonds. There are many similarities between these three-party agreements, but their differences will help businesses determine which is in its best interest.
So what exactly makes these two types of agreements unique from one another? In order to find that out, we’ll compare international surety bonds to letters of credit. So, if you’re on the fence about what kind of agreement you should pursue, this article is perfect for you.
International surety bonds 101
Not sure what international surety bonds (ISB) are? Here’s an explanation.
What are surety bonds? As a business owner, you have most likely heard of the term before. After all, many businesses are required to have surety bonds, depending on what they do. So, before we move on to defining what an international surety bond is, let’s discuss the more general term first.
Surety bonds are three-party agreements that provide financial coverage in the event that something goes wrong with a project. These three parties are the obligee, the principal, and the surety.
The obligee is the party that requests the bond — for example, a government body or a customer. The principal is the business required to obtain the bond. The surety is the mediator and financial guarantor between obligees and principals. Their job is to guarantee that everything stipulated in the agreement goes through.
Based on this short description, you might say that surety bonds are a type of insurance. And indeed, insurance companies are the ones who issue these bonds, to begin with. While there are lots of similarities there, surety bonds are not insurance.
Now, you might wonder what makes international surety bonds (ISBs) different from the regular ones. Well, as their name suggests, ISBs cover all of the obligations from the agreement, but not in the country where the principal is domiciled. Rather, they cover obligations in other countries, in accordance with their laws and regulations.
Types of ISB
Broadly speaking, surety bonds fall under one of three categories – contract bonds, commercial bonds, court bonds. Of course, each of those categories can have thousands of subtypes of bonds, depending on what they cover. In terms of ISBs, here’s a list of some subtypes you can expect to see:
- Maintenance bonds
- Warranty bonds
- Performance bonds
- Advanced payment bonds
- Judicial bonds
- Supply bonds
- Customs bonds
Letters of credit 101
And here’s an explanation of letters of credit.
Letters of credit (LCs) are bank-issued documents that also involve a three-party agreement. In this agreement, the bank is effectively the same as the surety in an ISB. In other words, the bank has to make sure that the obligations are fulfilled properly, and it also has to provide compensation in the case of something going wrong.
The other two parties that make up an LC agreement are the beneficiary (i.e. the seller) and the buyer. Beneficiaries are entitled to draw all of the funds they need to cover the cost of a project if the buyer doesn’t honor the agreement properly. Buyers, on the other hand, are the ones who secure LCs in order to guarantee that they will meet all of the stipulated points of the agreement.
Types of LC
Since there are many different types of businesses, the number of various LCs grows every year. Broadly speaking, you might end up acquiring one of the following types of letters:
- Irrevocable LC (you cannot cancel or modify it without explicit consent from the beneficiary)
- Revocable LC (more or less the opposite of irrevocable LC)
- Confirmed LC (the LC is confirmed by the issuer’s and the seller’s bank, as well as any other relevant bank involved)
- Unconfirmed LC (only the bank that issues the LC will be liable for payment)
- Stand-by LC (closer to the bank guarantee; this type is quite flexible to both the buyer and the seller of the letter)
- Back-to-back LC (a second intermediary LC issued on the basis of the first one)
- Transferable LC (the seller can assign parts of the letter to any other third party if the need arises)
- Payment at sight LC (the LC seller receives immediate payment after submitting the required documents)
- Deferred payment LC (unlike at sight LC, these letters don’t require upfront payment, and the party can pay it at a later date)
- Red Clause LC (sellers can request an advance for an agreed amount of the LC)
ISB vs LC: similarities and differences
While both ISBs and LCs are quite similar, they are not the same. If you still haven’t decided on choosing one of the two, here’s a list of differences that might help your decision along:
- An ISB does not have any negative effects on the credit of the contractor or on their borrowing capacity; an LC will appear on the contractor’s balance sheet, which might actually affect their credit in the future
- Banks tend to charge hidden fees for their letters of credit; sureties tend to have small, transparent fees (if any)
- An ISB can cover the entire duration of a project; LCs tend to have fixed-term validity, usually around a year
- Banks impose collateral requirements and freeze cash assets with their LCs while ISBs only require a payment of the surety premium.
- A surety will investigate any claim made against the bond in order to make sure that no contract breach took place; with LCs, a beneficiary can withdraw funds as they please, and the buyer can’t really challenge a false breach claim easily
- Both ISBs and LCs set their premium costs to a percentage of the full bond/LC amount; bank premiums are usually lower, but surety bonds cam save money in the long run and allow the principal to experience greater liquidity.
Which option is right for you?
ISBs and LCs are, for the most part, not an obligation for any business. After all, you still have the option of regular insurance. However, both options, while different in some crucial ways, can greatly help you if you need financial safety. Hopefully, this article has helped you choose the option that works best for your particular business.