KBRA Affirms Ratings for Heritage Financial Corporation

KBRA affirms the senior unsecured debt rating of BBB+, the subordinated debt rating of BBB, and the short-term debt rating of K2 for Olympia, WA-based Heritage Financial Corporation (NASDAQ: HFWA). Additionally, 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 HFWA's subsidiary, Heritage Bank ("the bank"). The Outlook for all long-term ratings is Stable.

Key Credit Considerations

Management’s consistent and diligent balance sheet stewardship, anchored by its capital and liquidity management practices, has served the bank over time and continues to underpin the ratings. Consolidated regulatory capital ratios, while reflective of RWA deployment in recent quarters, remain commensurate with KBRA rated peers; the parent company does not rely on leverage.

Underpinning the bank’s relatively solid and stable earnings performance is the low cost of deposits (1.38% as of 1Q25), which is buoyed by the historically sizeable base of noninterest-bearing deposits (28% of total deposits as of 1Q25). Both the cost and mix of total deposits compare favorably with rated peers. Realized losses on AFS securities have been incurred during the past two years to re-balance the portfolio with higher book yield investments through duration extension; RMBS has held steady at roughly 50% of the AFS portfolio mix. Incurred losses impacted pre-tax ROAA in 2024 and 2023 by approximately 0.32% and 0.17%, respectively.

The bank’s relatively rich deposit base – intrinsically correlated to the economic dynamism of the local economy – has afforded management the ability to strategically fund loans with relatively lower yields, which portends lower credit risk, ceteris paribus. While loan quality across the banking sector has been sturdy for years, the bank’s cumulative net loan losses since 2021 total only $1.9 million (through 1Q25).

Asset liquidity has declined in recent quarters as management has increased the proportion of loans. Loans in relation to total assets have risen to a modest 67% of total assets, compared to 60% at YE23. Cash and short-term investments, plus the AFS investment portfolio, represent a peer-like 17% of total deposits, whereas the same level was 24% at YE23 (on basically unchanged deposit levels). Uninsured deposits remain significant (40% of total deposits), reflective of the relatively cash-rich local economy and the nature of the bank’s deposit base, which includes a large percentage of corporate deposits. Contingent borrowing capacity, plus the above-mentioned asset liquidity, net of pledged AFS securities, covers uninsured deposits by a ratio of 1.1x.

Rating Sensitivities

A rating upgrade is not likely in the intermediate term barring an exogenous event. Conversely, although unlikely, a shift to aggressive regulatory capital management or a deterioration in loan quality such that it causes earnings performance to become volatile or regularly trail its rated peers could drive a rating reassessment. Any deterioration in on-balance sheet (asset) liquidity relative to potentially volatile sources of funding, including uninsured deposits, could also cause the ratings to be reassessed.

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