What is a bond?
What does the term “bond” really mean? Unfortunately, there are a lot of bonds out there – from surety bonds to treasury bonds to other bonds, James Bonds.
This is a simple explanation of a surety bond. A guarantee bond or surety is a promise to pay someone, called the obligee, a specific dollar amount if someone else, called the principal, fails to comply with some commitment. These commitments are typically something that is specified in a contract and are especially common in construction contracts. The surety bond safeguards the obligee against losses arising from the principal's failure to comply with the commitment.
A typical surety bond contains three different parties:
1) The obligee – this is the person that gets paid if someone else doesn’t do what they said they’d do;
2) The principal – this is the person who made the commitment; and
3) The surety – this is the person that pays the obligee because they assured the obligee that the principal can do the job.
A side note – European surety bonds are issued by banks and are called “Bank Guarantees” in English and “Caution” in French. They pay money to the limit of guarantee in the event of the default of the Principal to promote his obligations to the Obligee, without referring by the Obligee to the Principal and against the Obligee's single confirmed declaration of case to the bank.
Back to the US – with a surety bond, the surety agrees to support, for the benefit of the obligee, the legal guarantees (commitments) made by the principal if the principal fails to uphold its assurances to the obligee.
The contract is formed so as to cause the obligee to deal with the principal, i.e., to show the trustworthiness of the principal and guarantee performance. Thus, the obligee gets some comfort with regard to the principal so that they can form a contract with the principal.
The principal will pay a price (usually annually) in exchange for the surety’s (bonding firm) fiscal backing so that they can get this surety bond. The principal is willing to pay for the surety bond because then they can get the contract and start some profit-paying work.
So, what happens if the principal cannot perform? Well, that circumstance, the surety will investigate the situation and determine if there is a valid claim (sometimes, the obligee complains, but that complaint is without merit). If the claim is valid, then the surety will pay it. The surety then looks to the principal for reimbursement of the amount paid on the case and any lawful charges sustained.
So, what happens if the principal defaults and the surety is also insolvent? In those cases, the surety bond is worthless. That’s why the guarantee on a bond is normally an insurance policy company whose solvency is verified by personal audit, government policy, or both.