Default Risk Characteristics of Construction Surety Bonds

Abstract

A construction surety bond helps a development project to proceed smoothly. This financial product has supported the rapid economic growth of several emerging markets, including the Republic of Korea. In this study, by using a unique and high-quality dataset, the authors analyze construction surety bonds to estimate their default probabilities. The results have several empirical implications. First, firm characteristics, such as firm size and leverage ratio, influence the surety bond default risk; the safety and liquidity measure are especially robust indicators. The result also confirms that account receivables can increase the default risk. Second, endogenous variables of the surety bond are also robust indicators of default. Because a construction surety bond itself has additional information about a company starting a new construction project, those variables can contribute to indicating default risk. Finally, default forecasting based on this model has much greater forecasting power than models based on the credit rating.

TOPICS: Project finance, statistical methods, credit risk management, emerging markets