Understanding surety bonds for credit managers—how they work as a risk mitigation tool

Construction has not always been the structured, contract-driven industry it is today. In its early days, project owners, contractors and suppliers operated with little formal protection—leaving all parties vulnerable when a project went sideways.

As the industry grew, so did the need for accountability. Surety bonds emerged as an answer, evolving from informal agreements into legally mandated instruments of financial protection.

Why it matters: In construction credit, surety bonds are one of the most powerful tools available for securing payment and managing risk.

Understanding surety bonds

A surety bond is an agreement in which one party (surety) guarantees another party (the obligee) that a third party (the principal) will perform according to the bond, contract or other obligation.

Surety bonds fall under two distinct categories: commercial bonds and contract bonds. Although similar, they serve different purposes and apply to different industries. Commercial bonds ensure that a business or individual complies with all applicable laws and regulations. Courtesy of Hannover Re, we’ve provided a list of examples:

• Court Bonds (fiduciary): Guardians, liquidators
• Court Bonds (judicial): Appeal bonds, mechanic’s liens
• Licenses and Permits: Sales tax bonds, contractor’s license bonds
• Public Official Bonds: Treasurer, tax collector, court clerk, notary bonds
• Bonds protecting the U.S. government: Customs bonds, exercise bonds
• Miscellaneous Bonds: Bonds to guarantee payment of utility bills, Workers’ Comp Bonds for Self-Insurers

Contract bonds, widely used in construction credit, ensure contractors meet contractual obligations and protect project owners from financial losses, with performance bonds often covering the complete contract value. Examples include:

• Bid Bonds
• Performance Bonds
• Payment or Labor and Materials Bonds
• Maintenance Bonds
• Supply Bonds

Surety bonds in construction credit

Surety bonds became enforceable in 1894 when Congress passed the Heard Act, requiring construction projects with federal funding to include one. In 1935, Congress passed the Miller Act at the federal level. Many states followed with their own version, known as the Little Miller Act, extending these protections to state-funded projects. Together, they required general contractors to post two primary bonds:

• Performance Bond: Protects the property owner to assure the construction contract can be fulfilled.
• Payment Bond: Protects downstream subcontractors, material suppliers and service providers in the event of non-payment.

If a city is looking to build a bridge, for example, the city would most likely apply for a bid bond, guaranteeing that if the bidder wins the project, they will sign the contract and provide the required performance and payment bonds. This arrangement protects project owners from financial loss in the event a winning bidder backs out or fails to start the project.

“Although the surety would step in to cover the losses, it’s important to know that the obligor remains ultimately liable for the loss and the surety would look for reimbursement from the principal in case of loss,” said Antje Seiffert-Murphy, senior market representative at Hannover Re Services USA, Inc. during an NACM webinar, Surety Bonds for Credit Managers.

By requiring a payment bond on a construction project, creditors gain a direct line of recourse against the surety should the contractor fail to pay. This shifts the burden of collection away from the creditor and onto the bonding company, reducing both financial exposure and the time spent pursuing payment.

The bottom line: For credit professionals, surety bonds serve as more than just a safety net—they actively strengthen a creditor’s position on a project. In cases where a contractor becomes insolvent, a surety bond can be the difference between recovering payment in full and absorbing a significant loss.

NACM’s Secured Transaction Services (STS) offers a Payment Bond Investigation Service to help manage surety bond agreements. For additional questions, reach out to STS representative Chris Ring at chrisr@nacm.org or join our Construction Credit Thought Leader Forum to exchange ideas and connect with others in the industry.