Finance term
Performance Bond
Also known as: completion bond, contract bond
Definition
A performance bond is a surety guarantee that a contractor will complete a project according to contract specifications. Required on most government construction contracts and many private construction projects. Bond premiums typically run 0.5–3% of the contract value.
Detailed explanation
A performance bond is issued by a surety company (an insurance company licensed to write surety bonds) and guarantees that if the contractor (principal) fails to complete the project per contract, the surety will either complete the work or pay the project owner (obligee) up to the bond amount (typically 100% of the contract value).
The Miller Act (for federal contracts over $150,000) and state Little Miller Acts mandate performance bonds on public construction contracts. These requirements ensure project owners — government entities funding projects with taxpayer money — have financial protection if the contractor defaults. Private owners frequently require performance bonds on large capital projects by contract, not by law.
The surety underwriting process is rigorous — sureties conduct deep credit and financial analysis because they are guaranteeing the contractor's performance, not just the bond amount. Key factors: contractor financial statements (working capital, equity), work-in-progress (WIP) schedule (current backlog vs. capacity), years in business, key personnel continuity, and track record of project completion. Surety limits (called 'surety credit') are set based on this analysis, similar to a bank credit limit.
Premium is quoted as a percentage of the contract amount and paid at bond issuance. Premium is non-refundable and earned immediately. For contractors, surety capacity is a competitive advantage — large general contractors with strong surety programs can bid on larger projects that smaller firms cannot because they lack surety capacity.
◈ Worked example
- Federal contract: Contractor wins $2M federal building renovation. Miller Act requires performance bond (100% of contract = $2M) + payment bond (100% = $2M). Surety charges 1.5% premium on performance bond ($30,000) + 0.5% on payment bond ($10,000). Total bonding cost: $40,000 (2% of contract).
- Private construction: Developer requires 100% performance bond on $10M commercial construction contract. Contractor's surety issues $10M bond at 1% premium ($100,000). Contractor defaults at 60% completion. Surety hires replacement contractor — completion cost is $4.5M (vs. $4M remaining contract value). Surety pays $4.5M, recovers from contractor under indemnity agreement.
- Surety underwriting: Contractor applies for $5M single project surety credit. Surety reviews: $800K working capital (minimum 10% of requested capacity = $500K required — adequate), 15 years in business, 3 open projects totaling $4M (within capacity guidelines), strong financial statements. Surety approves $5M single project limit at 1.2% premium.
Common questions
The most-asked questions about Performance Bond — answered straightforwardly.
What is the difference between a performance bond and insurance? +
Insurance protects the insured (policyholder) against losses. A surety bond protects the obligee (project owner) against the principal's (contractor's) non-performance. When a surety pays a bond claim, it seeks full reimbursement from the contractor under an indemnity agreement — the contractor ultimately bears the loss. Insurance has no such recovery expectation. Performance bonds are a three-party guarantee mechanism, not an insurance transfer of risk.
How much does a performance bond cost? +
Performance bond premiums range from 0.5–3% of the contract value, depending on the contractor's financial strength, the project type and complexity, and the surety's risk assessment. Financially strong contractors with long track records pay the lowest rates (0.5–1%). Newer or financially weaker contractors pay higher rates or may be unable to obtain bonds. The premium is paid upfront and is non-refundable.
Can I get a performance bond with bad credit? +
It is difficult but not impossible. Sureties look at overall financial health, not just credit scores — a contractor with strong working capital, equity, and project track record may obtain bonding despite credit blemishes. However, significant derogatory history (prior bond claims, bankruptcies, large unpaid debts) typically disqualifies contractors from standard surety programs. Some specialty sureties work with higher-risk contractors at significantly higher premiums.
Further reading
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