Surety Bond vs Letter of Credit: Which Construction Guarantee Protects You Better in Ontario?

A surety bond investigates before it pays. A letter of credit pays before it investigates. That single difference shapes everything else: your cash flow, your risk exposure, your ability to fight an unfair claim, and whether your subcontractors get paid.

Both instruments guarantee a construction obligation, but they are not interchangeable. Ontario contractors and project owners who treat them as equivalent alternatives often discover the hard way that one offers significantly deeper protection than the other. Understanding where they diverge is not academic. It is a practical decision that affects your balance sheet, your banking relationships, and your ability to bid on the next project.

On Default vs On Demand: The Core Distinction

The most important difference between a surety bond and a letter of credit is what triggers payment.

A surety bond is an "on default" instrument. When a project owner declares a contractor in default, the surety company investigates the claim. It reviews the contract terms, examines the circumstances, determines whether the contractor actually breached its obligations, and confirms the owner met its own contractual duties. The surety only pays after validating that a genuine default occurred. This protects the contractor from frivolous or exaggerated claims.

A letter of credit is an "on demand" instrument. When the beneficiary presents the correct documentation to the issuing bank, the bank pays. There is no investigation into whether the contractor actually defaulted. The bank's obligation is to verify documents, not to assess the merits of a dispute. If the owner submits proper paperwork claiming a breach, the bank pays out, and the contractor is left to pursue recovery after the fact.

The Surety Association of Canada describes this distinction clearly in its position paper on surety bonds versus letters of credit: surety bonds "support the fairness of the underlying construction contract and require an owner to honour its obligations and demonstrate that a default has occurred."

For contractors, this difference is not theoretical. An on-demand instrument means any documentation-compliant claim results in immediate payment, justified or not.

Coverage Depth: 100% vs 5-10%

Surety bonds and letters of credit do not provide the same level of coverage, and this difference is significant for both contractors and project owners.

A performance bond typically covers 100% of the contract value. If the contractor defaults, the surety is responsible for ensuring the project gets completed at the original contract price. A labour and material payment bond provides additional 100% coverage for subcontractor and supplier payments.

A letter of credit is usually issued for 5% to 10% of the total contract value. It does not guarantee project completion. If a contractor defaults on a $5 million project and the letter of credit is $500,000, the project owner receives $500,000 and is left to manage completion on their own, at their own additional expense. Subcontractors and suppliers receive nothing from the letter of credit.

This coverage gap matters most when things go wrong. A bonded project owner ends up with a completed project. A project owner holding a letter of credit ends up with cash that may or may not cover the cost of finding a replacement contractor and finishing the work.

Cash Flow and Working Capital

The financial mechanics of these two instruments affect your business in opposite ways.

When a surety company issues a bond, it extends a guarantee backed by the surety's own assets and reserves. The contractor does not pledge collateral. The bond amount counts against the contractor's total bonding facility, but it does not restrict cash, lock up bank credit lines, or reduce borrowing capacity. Your working capital remains available for materials, payroll, equipment, and other operational needs.

A standby letter of credit works differently. Canadian banks typically require collateral to back the letter of credit, and for many contractors, that means 100% cash margin or equivalent credit facility usage. A $500,000 letter of credit can mean $500,000 of your cash or credit capacity is frozen for the duration of the project. That capital cannot be used to run your business.

The opportunity cost compounds over long projects. A two-year infrastructure contract with a letter of credit ties up that collateral for two years. The contractor pays annual bank fees (typically 1% to 3% of face value for standby letters of credit) on top of the frozen capital. Surety bond premiums are a one-time cost, generally 1% to 3% of the bond amount depending on the contractor's financial profile and claims history, with no collateral requirement.

Subcontractor and Supplier Protection

This is where the difference becomes most concrete for the broader construction supply chain.

A labour and material payment bond guarantees that subcontractors and suppliers with direct contracts to the bonded contractor will be paid for their work and materials. If the general contractor fails to pay, the surety steps in. Subcontractors do not need to file construction liens to recover payment. They submit a claim to the surety, and if validated, they are paid in full.

As of January 1, 2026, amendments to the Ontario Construction Act further strengthen this protection. Under the updated provisions, sub-subcontractors and other lower-tier claimants may recover under a labour and material payment bond without needing to preserve or perfect a lien.

A letter of credit provides no protection whatsoever to subcontractors or suppliers. It pays only the named beneficiary, which is typically the project owner. Unpaid subcontractors must pursue their own remedies through the courts or the lien process.

For project owners, this distinction also matters. A payment bond removes the administrative burden of managing lien claims on the project. Without one, the owner may face multiple liens from unpaid subcontractors, which can delay project closeout and create legal complications.

Ontario Law: Mandatory Bonding on Public Contracts

Ontario does not treat surety bonds and letters of credit as equivalent. Under Section 85.1 of the Construction Act, contractors on public contracts valued at $500,000 or more must provide both a performance bond and a labour and material payment bond. Each bond must have coverage of at least 50% of the contract price (or $50 million, whichever is less, for contracts exceeding $100 million).

A "public contract" includes any contract where the owner is the Crown, a municipality, or a broader public sector organization. This covers provincial highway contracts with the MTO, municipal infrastructure work, school board projects, hospital construction, and similar public-sector work.

The prescribed bond forms are standardized. The CCDC bond forms (CCDC 220 for bid bonds, CCDC 221 for performance bonds, CCDC 222 for payment bonds) were updated in 2024 with more detailed provisions for claim response timelines and dispute resolution.

Letters of credit remain common on municipal subdivision and site-plan agreements, where they secure obligations like grading, servicing, and landscaping. But for construction contracts themselves, particularly public contracts, Ontario law specifically mandates surety bonds because they provide deeper protection and fairer claims processes.

The Prequalification Advantage

Surety bonding includes a benefit that letters of credit cannot replicate: independent third-party prequalification.

Before issuing a bond, the surety company evaluates the contractor's financial statements, credit history, management experience, equipment capacity, and work-in-progress. This is the underwriting process, built around the "three Cs" of surety: character, capacity, and capital. The surety needs confidence that the contractor can actually perform the contract before it guarantees that performance.

For project owners, this prequalification serves as an independent quality filter. A bonded contractor has been vetted by a surety, which has its own financial stake in the outcome. A contractor presenting a letter of credit has only demonstrated access to bank credit, which tells the owner nothing about construction capability, management quality, or track record.

For contractors, building a bonding relationship over time increases your bonding capacity, allowing you to bid on larger projects. A clean track record with your surety results in better rates and faster bond issuance. Letters of credit do not build this type of professional credential.

Duration and Continuity

A surety bond remains in force for the life of the contract. It does not expire on a fixed date. If the project runs long due to weather delays, change orders, or scope adjustments, the bond coverage continues automatically. It also survives changes in ownership of the contractor's business.

A standby letter of credit has a fixed term, typically one year, with renewal at the bank's discretion. If the project extends beyond the letter of credit's term, the contractor must arrange a renewal. The bank can decline to renew, refuse to extend the amount, or increase collateral requirements. This creates a gap risk that surety bonds eliminate entirely.

When Each Instrument Makes Sense

Surety bonds are the right choice for:

• Public contracts in Ontario (mandatory above $500,000)
• Performance and payment guarantees on any construction project
• Projects where subcontractor and supplier protection matters
• Contractors who need to preserve cash flow and borrowing capacity
• Long-duration projects where fixed-term instruments create renewal risk
• Building a bonding track record for larger future projects

Letters of credit may be appropriate for:

• Municipal subdivision and site-plan agreements (grading, servicing, landscaping)
• Short-term financial guarantees unrelated to construction performance
• International transactions where surety bonds are not recognized
• Situations where the project owner specifically requires a letter of credit and will not accept alternatives

In practice, most construction projects in Ontario are better served by surety bonds. The deeper coverage, fairer claims process, subcontractor protection, and cash flow preservation make bonds the stronger instrument for both contractors and project owners.

Getting the Right Guarantee for Your Project

The choice between a surety bond and a letter of credit is not just a preference. It determines how much of your project is actually covered, whether you get a fair hearing on disputed claims, whether your subcontractors are protected, and how much working capital you sacrifice.

If you are bidding on public projects in Ontario, bonding is not optional. But even on private contracts, the advantages of surety bonds over letters of credit are substantial enough that most contractors benefit from bonding.

An experienced surety broker can help you understand your bonding capacity, compare the true cost of bonds versus letters of credit for your specific projects, and build a bonding program that grows with your business. Contact Roughley Insurance Brokers to discuss your surety needs or get a quote on your next project.