Performance Bond

What Is a Performance Bond?

A performance bond is a form of financial security that a party provides to show it will carry out the work or obligations it has agreed to. If the party fails to perform, the person it owes the obligation to can make a claim on the bond to recover losses or cover the cost of getting the work finished. Performance bonds are most common in construction, where a contractor may be asked to post one before a project starts, but the concept appears in many commercial agreements.

Performance bonds generally take one of a few forms. A surety bond is issued by a surety company, which agrees to pay the beneficiary if the principal defaults and may then seek reimbursement from the principal. A bank may instead issue a letter of credit that pays when specified conditions are met. A party may also deposit cash or other collateral with the beneficiary or an escrow agent.

How It Works

Three parties are usually involved: the principal, who must perform the obligation; the beneficiary, who receives the protection; and the guarantor, such as a surety or bank, which backs the promise. If the principal completes the work as agreed, the bond is released and no money changes hands. If the principal defaults, the beneficiary can make a claim, and the guarantor pays up to the bond's stated amount, subject to the bond's terms.

Performance Bonds in Futures Markets

In futures trading, "performance bond" is the term exchanges and regulators often use for the good-faith deposit a trader must hold to open and maintain a futures contract position. It is not a fee or a payment for the contract itself. It works much like margin in that it protects the clearinghouse and the other side of the trade against losses. Daily mark-to-market adjustments move gains and losses in and out of the account, and a trader whose balance falls below the required maintenance margin may receive a margin call.

Why It Matters to Investors

For individual investors, performance bonds are most relevant indirectly. Companies that bid on public projects may need to post bonds, which can affect their ability to win contracts. In futures trading, the required deposit determines how much capital is tied up and how quickly losses can require additional funds, so understanding it is useful before trading leveraged products.