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.
Any professional business across the world will tell you that having some sort of insurance is important. Backup payment plans let business owners operate without having to worry about losses. After all, if a loss does happen, or if something unexpected interferes with the project, the businesses can always claim compensation and proceed with the project.
Of course, buying insurance can be a pricey, difficult process, which is why people look for alternatives. Today, having a three-party agreement that covers a project or a business in case of something going wrong is the norm. There are two such agreements that businesses go for, and while they are similar, in a lot of ways they are different. Those two are surety bonds and letters of credit.
But what exactly makes these two types of agreement stand out? In order to find that out, we’ve decided to 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. In fact, you’ve probably encountered it more than the term ‘letters of credit.’ After all, nearly all modern businesses tend to own at least several 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 a business or a company financial coverage. These three parties consist of the obligee, the principal, and the surety. Obligee is the party that requests the bond — for example, a government body or a business. On the other hand, principals are the ones who provide the bond. Sureties are the mediators between obligees and principals. Their job is to guarantee that everything stipulated in the agreement goes through. In other words, if the obligee seeks compensation, the surety is required to provide it.
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. However, 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 four categories — contract bonds, commercial bonds, court bonds, and fidelity 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 acquire:
- 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 purchase 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 additional rigorous terms with their LCs; ISBs are far more flexible in that regard
- 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 save more money in the long run
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.