In recent years, the availability of surety credit capacity has increased dramatically as a method of replacing or complementing the use of bank instruments such as letters of credit. Product evolution and education has encouraged the beneficiaries of letters of credit to consider surety credit solutions in a couple of basic deal structures:
- Demand surety bonds – evergreen instruments that are very comparable to a letter of credit in structure and form.
- Surety backed letters of credit – bank fronted paper ahead of surety credit facility capacity.
Whether a surety credit solution is prescribed by your organization’s contract, or regulatory counterparty, or is negotiated and bespoke in nature, there are four key benefits for your organization once a surety facility is established:
1. Balance sheet relief: The surety credit engagement is “off balance sheet” and unsecured in nature. The use of surety bonds or surety backed letters of credit will not tie up your organization’s operating line, impact working capital, or have any bearing on your debt covenant ratios. Your organization’s liquidity position will improve when surety credit is deployed to displace letters of credit issued from a secured lending facility.
2. Increased credit capacity: Establishing a surety credit facility for your organization means developing a separate tranche of credit capacity that will supplement existing lending facility capacity. This inflated access to capital creates capacity head room or a “capacity cushion” that will help your organization to protect itself against potential unforeseen cash flow constraints. What makes surety credit particularly appealing is there is no cost for dormant capacity – the surety creditors do not charge stand-by or commitment fees to their clients.
3. Creditor diversification: Establishing a surety credit facility for your organization is a prudent way to manage your organization’s exposure to creditor counterparty risk (e.g. concentration risk). Here is some perspective on how surety credit will complement existing lending arrangements:
a. Because the surety creditor is in an unsecured position, they inherently line up behind your secured lenders in priority. The surety engagement should not impact or upset existing lending facility agreements. If necessary, an inter-creditor agreement can be used to reinforce where the surety creditor stands in priority with other lenders.
b. The surety creditors that issue demand instruments or backstop letters of credit have strong external credit ratings; generally in the range of Standard & Poor’s “A” to “AA+” (similar range of the big five banks in Canada).
c. The use of surety credit does not need to be an “all or nothing” initiative. Best practice is to build out a balanced portfolio with both bank and surety instruments in the mix. In addition to this, more than one surety creditor can be mobilized to issue bonds for your organization to further diminish creditor concentration risk (similar in form to building separate letter of credit bilateral facilities).
4. Cost savings: Surety bond rates can be substantially lower than letter of credit rates. Further to this, there are no transaction fees for the issuance of surety instruments, minimal (if any) cost to set up a surety credit facility and, as noted above, no standby or commitment fees for dormant surety capacity. The use of surety bonds or surety backed letters of credit can create significant cost savings for your organization when compared to banking solutions.
The surety credit industry is continually evolving in order to meet new security, performance guarantee, and collateral requirements that are prescribed in both contracts and legislation throughout industry. It is to the benefit of your organization’s treasury team to develop terms and capacity with surety creditors as a means of complementing existing and traditional lending arrangements. Whether surety credit capacity is used to issue demand bonds, or to backstop letters of credit, it will be a creative way to facilitate counterparty security requirements.
How Marsh Can Help
The Marsh Canada surety team has experience working with organizations across industries to advise on surety credit solutions. Please contact us to learn more.
