Loading the player...

What is a 'Construction Bond'

Construction bond is a type of surety bond used by investors in construction projects to protect against disruptions or financial loss due to a contractor's failure to complete the project or to meet contract specifications.

A construction bond is also called a construction surety bond or a contract bond.

BREAKING DOWN 'Construction Bond'

When a contractor vies for a construction job, he is usually required to put up a contract bond or construction bond. The construction bond provides assurance to the project owner that the contractor will perform according to the terms stated in the agreement. On larger projects, construction bonds may come in two parts - one to protect against overall job incompletion and another to protect against nonpayment of materials from suppliers and labor from subcontractors. 

There are generally three parties involved in a construction bond –the investor/project owners, the party or parties building the project, and the surety company that backs the bond. The project owner or investor, also known as the obligee, is typically a government agency that lists a contractual job that it wants done. To reduce the likelihood of a financial loss, the obligee requires that all contractors put up a bond. The contractor selected for the job is usually the one with the lowest bid price since investors want to pay the lowest amount possible for any contract.

By submitting a construction bond, a principal, that is the party managing the construction work, is stating that he can complete the job according to the contractual policy. The principal provides financial and quality assurance to the obligee that not only does he have the financial means to manage the project but that the construction will be carried out to the highest quality specified. The contractor purchases a construction bond from a surety which runs extensive background and financial checks on a contractor before approving a bond.

Sureties and Construction Bond Types

A surety is the financial guarantor of a construction bond, guaranteeing the obligee that the contractor will act in accordance with the terms established by the bond. Surety companies will evaluate the financial merits of the principal builder and charge a premium according to their calculated likelihood that an adverse event will occur. A surety can assist a contractor having cash flow problems and may also replace a contractor who abandons a project. There are three main types of construction bond provided by a surety:

  1. Bid bond: This bond is necessary to the competitive process bidding. Each contending contractor has to submit a bid bond along with their bids to protect the project owner in the event that a contractor backs out of the contract after winning the bid or fails to provide a performance bid, which is required to start working on the project.
  2. Performance bond: A bid bond is replaced by a performance bond when a contractor accepts a bid and proceeds to work on the project. The performance bond protects the owner from financial loss if the contractor’s work is subpar, defective, and not in accordance with the terms and conditions laid out in the agreed contract.
  3. Payment bond: This bond, also called a labor and material payment bond, is a guarantee that the winning contractor has the financial means to compensate his or her workers, subcontractors, and suppliers of materials.

When a contractor fails to abide by any of the conditions of the contract, the surety and contractor are both held liable. The owner can make a claim against the construction bond to compensate it for any financial loss that ensues if the principal fails to deliver on the project as agreed or for costs due to damaged or defective work done by the principal. In cases where the contractor defaults or declares bankruptcy, the surety is held responsible for compensating the project owner for any financial loss. A surety that takes on the liability of a claim can sue the contractor for the amount paid to the owner if the terms of the construction bond permits it.

Many things can go wrong in a large construction project. Because of this, construction bonds are almost a mandatory prerequisite of any project beyond a certain size, and for most (if not all) government and public works projects.

RELATED TERMS
  1. Bond Violation

    A bond violation is a breach of the terms of a surety agreement ...
  2. Bid Bond

    A bid bond is a debt secured by a bidder for a construction job, ...
  3. Surety

    A surety is the organization or person that assumes the responsibility ...
  4. Completion Bond

    A completion bond is a financial contract that ensures that a ...
  5. Performance Bond

    A performance bond is issued to one party of a contract as a ...
  6. Continuous Bond

    A continuous bond is a financial guarantee commonly used in international ...
Related Articles
  1. Investing

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  2. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  3. Investing

    Why Bond Prices Fall When Interest Rates Rise

    Never invest in something you don’t understand. Bonds are no exception.
  4. Investing

    How Interest Rates Impact Bond Values

    The relationship between interest rates and bond prices can seem complicated. Here's how it works.
  5. Investing

    Surprise! The Best Long-term Bond Investment May Be Savings Bonds

    A 20-year Series EE savings bond pays more interest than a 20-year Treasury bond. So are government-issued long-term bonds the best bet going?
  6. Investing

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
  7. Retirement

    Should I Invest in Bonds After I Retire?

    Yes, retirees should invest in bonds, but remember that not all bonds are safe investments. Seek the help of a financial advisor.
  8. Small Business

    Should You Hire Contractors or Employees for Your Small Business?

    Learn the pros and cons of hiring independent contractors instead of regular full-time employees. Find out about a potential risk for severe tax penalties.
  9. Investing

    U.S. Corporate Bonds: The Last Safe Place to Make Money

    There aren't many other sources right now for relatively safe, steady income.
RELATED FAQS
  1. What determines bond prices on the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market and why bond prices and yields ... Read Answer >>
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center