KBRA Publishes and Affirms Ratings for Heritage Financial Corporation

KBRA publishes and affirms the senior unsecured debt rating of BBB+, the subordinated debt rating of BBB, and the short-term debt rating of K2 for Heritage Financial Corporation (NASDAQ: HFWA or “the company”), a bank holding company headquartered in Olympia, WA. KBRA additionally publishes and 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 the bank subsidiary, Heritage Bank. On November 13, 2020, KBRA assigned a senior unsecured debt rating of BBB, a subordinated debt rating of BBB-, and a short-term debt rating of K3 for HFWA on an unpublished basis; KBRA also assigned deposit and senior unsecured debt ratings of BBB+, a subordinated debt rating of BBB, and short-term deposit and debt ratings of K2 for Heritage Bank on an unpublished basis. On May 24, 2021, KBRA subsequently upgraded the ratings for both entities to the current ratings, also on an unpublished basis. The Outlook for all long-term ratings is Stable.

Management’s conservative balance sheet stewardship, moored by its capital and liquidity management practices, continues to anchor the ratings. The CET1 ratio, as defined by the bank regulators, has consistently ranked in the upper echelon of the rated peer group average; in addition, the BHC does not employ financial leverage. The CET1 ratio, adjusted to include MTM losses within the aggregate AFS portfolio, was 11.3% at 1Q23.

The hallmark of liquidity management remains the relatively low level of loans in relation to deposits, which favorably positions the bank to manage funding in the current environment of extreme deposit volatility for regional and community banks. Contingent sources of funding (e.g., FHLB unused lines of credit) have been ample historically but may not always be available. While KBRA notes that the deployment of short-term investments into loans and longer duration investment securities in 2022 reduced on-balance sheet liquidity, it believes the bank currently has sufficient total resources (on- and off-balance sheet) to cover uninsured deposits and other potentially volatile sources of funding.

The bank’s NIM remains the key driver of profitability. In the context of moderate loan yields, the strong historical margin performance reflects the rich deposit base, accentuated by the large proportion of noninterest bearing deposits (which consistently average about 30%-35% of total deposits, encompassing the periods before and after the FRB’s most recent round of ZIRP and QE). Noninterest income, stable historically, comprises about 15% of total revenues annually and is more commensurate with peer averages now that gain on sale income has normalized for the industry.

In both 2020 and 2021, profitability metrics were impacted by several crosscurrents, but aided substantially in 2021 from revenue generation tied to participation in SBA’s Payment Protection Program; profitability moderated in 2022, as a result, but remained in line with rated peers on a risk-adjusted basis. While the cost of total funding for the sector has risen sharply, accelerating in 1Q23, KBRA anticipates that pre-provision earnings at HFWA will remain competitive due primarily to the nature of the deposit base, stability of noninterest income, and well managed expense base.

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Methodologies

Financial Institutions: Bank & Bank Holding Company Global Rating Methodology

ESG Global Rating Methodology

Disclosures

Further information on key credit considerations, sensitivity analyses that consider what factors can affect these credit ratings and how they could lead to an upgrade or a downgrade, and ESG factors (where they are a key driver behind the change to the credit rating or rating outlook) can be found in the full rating report referenced above.

A description of all substantially material sources that were used to prepare the credit rating and information on the methodology(ies) (inclusive of any material models and sensitivity analyses of the relevant key rating assumptions, as applicable) used in determining the credit rating is available in the Information Disclosure Form(s) located here.

Information on the meaning of each rating category can be located here.

Further disclosures relating to this rating action are available in the Information Disclosure Form(s) referenced above. Additional information regarding KBRA policies, methodologies, rating scales and disclosures are available at www.kbra.com.

About KBRA

Kroll Bond Rating Agency, LLC (KBRA) is a full-service credit rating agency registered with the U.S. Securities and Exchange Commission as an NRSRO. Kroll Bond Rating Agency Europe Limited is registered as a CRA with the European Securities and Markets Authority. Kroll Bond Rating Agency UK Limited is registered as a CRA with the UK Financial Conduct Authority. In addition, KBRA is designated as a designated rating organization by the Ontario Securities Commission for issuers of asset-backed securities to file a short form prospectus or shelf prospectus. KBRA is also recognized by the National Association of Insurance Commissioners as a Credit Rating Provider.

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