KBRA Affirms Ratings for Heritage Commerce Corp

KBRA affirms the senior unsecured debt rating of BBB+, the subordinated debt rating of BBB, and the short-term debt rating of K2 for San Jose, California-based Heritage Commerce Corp (NASDAQ: HTBK) ("Heritage" or "the company"). In addition, KBRA affirms the deposit and senior unsecured debt ratings of A-, the subordinated debt rating of BBB+, and the short-term deposit and debt ratings of K2 for its subsidiary, Heritage Bank of Commerce. The Outlook for all long-term ratings is Stable.

Key Credit Considerations

The ratings are supported by HTBK’s conservative approach to liquidity and capital management, which has been exhibited throughout the company’s contemporary operating history and underscored by a loan-to-core deposit ratio of 74% and CET1 ratio of 13.6% at 1Q25. The discipline within those respective categories shielded the company during the more uncertain credit and liquidity environment in recent years. Moreover, despite being situated in Silicon Valley, core deposit balances were largely flat during the period of bank failures. Given the utilization of the reciprocal network (21% of balances as of 1Q25), uninsured deposits have decreased to 45% of total deposits compared to 64% entering 2023. While we recognize that this level remains above peers, it is offset by ample liquidity sources, noting on-balance sheet cash of ($745 million or 14% of assets at 1Q25). Moreover, the company has been able to capture some deposit and lending relationships from failed institutions in footprint, evidenced by ~8% core deposit growth in 2024.

Over the years, HTBK’s NIM has closely tracked the shifting interest rate environment, reflecting the company’s asset-sensitive balance sheet. NIM declined meaningfully following the emergency rate cuts during the pandemic, driven not only by lower rates but also excess liquidity, before rebounding sharply during the Fed’s rate hiking cycle in 2022 and 2023. However, gains were reversed in the latter half of 2023, as deposit costs accelerated in response to heightened sensitivity following regional bank failures and the persistence of a higher-for-longer rate environment. However, NIM appears to have bottomed, rising in consecutive quarters, to 3.39% in 1Q25. While this compares favorably to peers, it remains well below the 4.12% peak in 4Q22 and the pre-pandemic normalized range of 4.00% to 4.44%. Looking ahead, margin expansion should be supported by the reinvestment of maturing short-duration securities at higher yields, repricing of longer-dated loans, and modest loan growth. As such, management expects NIM to drift modestly higher over the course of 2025 and remains confident in expansion even in a declining rate scenario. Given HTBK’s reliance on spread income (with fee income accounting for only ~5% of total revenue), maintaining a healthy NIM is critical. That said, with deposit costs already low (1.54% in 1Q25, among the lowest in the KBRA-rated universe), the ability to reprice downward in a sharply lower rate environment is limited, which could pose a headwind if the Fed adopts a more aggressive easing stance. If the interest rate environment remains relatively stable, or if rate cuts occur at a more measured pace, we believe that ROA is likely to trend higher and move closer in line with peers (ROA was 0.85% in 1Q25). Recent returns have also been pressured by investments in technology, and talent, particularly at the executive level, which contributed to a steady increase in operating expenses (2.1% of average assets in 2024 and 1Q25, up from 1.9% in 2023). However, with anticipated improvement in NIM and continued balance sheet growth, the latter expected to support positive operating leverage, we believe that profitability has room to improve.

Heritage's operations are largely concentrated in the Bay Area, which, which we note has a unique volatility that can impact local real estate values. Mitigating these concerns, the company's credit quality has been pristine in recent years, which we believe is partially due to prudent underwriting and robust monitoring. To illustrate, the ICRE portfolio (299% of risk-based capital at YE24), maintains an average LTV and DSCR of ~40% and ~2.2x, respectively. Investor office is above average (9% of total loans), though management has noted divergence between the struggling San Francisco market (7% of the office book), while the remainder is fairly granular and largely operated in suburban markets. Also, in the event of unforeseen credit issues, we take comfort in Heritage’s strong loss-absorbing capacity, supported by solid earnings power and above-peer capital and reserve levels that are expected to be stable to slightly improving moving forward.

Rating Sensitivities

A rating upgrade is not expected in the medium term, though increased scale/market share in the current footprint, combined with a higher level of revenue diversity, while maintaining a conservative stance with capital and liquidity management could facilitate positive rating momentum over the longer horizon. Conversely, a downgrade is unlikely, though any material deterioration among key financial ratios, specifically credit or liquidity issues, or more aggressive capital management, could potentially pressure the ratings.

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