Detailed Narrative
Kitsap Bank Integration & Expense Outlook
The integration with Kitsap Bank is proceeding as planned, with systems conversion scheduled for late September. This integration is causing elevated noninterest expenses, which are projected to be in the $64 million to $65 million range for Q3 FY26, before decreasing to a run rate of $56 million to $57 million in Q4 FY26 as merger-related costs subside and contract/FTE costs are reduced. Management confirmed that the $18 million in annualized cost saves from the acquisition are on track to be realized.
Net Interest Margin Dynamics
The net interest margin increased 3 basis points to 3.99% in Q2 FY26, or 8 basis points when adjusting for a Q1 interest recovery. This improvement was primarily driven by increased yields on the investment portfolio and a decrease in the cost of deposits. Management anticipates a continued, though more moderate, upward trajectory for NIM, fueled by new loans and repricing within the existing loan portfolio, as the average note rate of 5.72% is significantly lower than new loan rates of 6.40%.
Loan Production and Pipeline
Commercial teams closed $339 million in new loan commitments in Q2 FY26, a significant increase from $166 million in Q1 FY26, driven by increasing loan demand. The commercial loan pipeline remained strong at $628 million. However, loan prepayments and payoffs also increased to $152 million, up from $119 million in Q1 FY26, partially offsetting the higher production. The company expects annualized loan growth to be in the mid-single-digit range for the next couple of quarters, assuming continued elevated prepayments.
Deposit Trends and Funding Costs
Total deposits decreased $210 million in Q2 FY26, attributed to seasonal tax payments, a $67 million outflow from a single large commercial customer, and a $48.5 million reduction in brokered CDs. Adjusted for these factors, deposits were down 1.3% in the quarter compared to 1% in Q2 FY25. The cost of interest-bearing deposits decreased to 1.67% from 1.71% in Q1 FY26, with a spot rate of 1.64% at quarter-end. Management expects gradual increases in deposit costs going forward⏳ due to market competition, but remains competitive on rates for new relationships.
Credit Quality Stability
Credit quality remained strong and stable, with a reversal of provision for credit losses of $921,000 in Q2 FY26. Nonaccrual loans increased modestly by $500,000 to $15.5 million, representing 0.27% of total loans, with $4.2 million in government guarantees. Substandard loans declined by $15.9 million, improving to 1.8% of total loans. Net charge-offs remained very low at $234,000 for the quarter, or 0.03% of total loans on an annualized basis for the first six months.
Capital Management and Balance Sheet Optimization
The company's regulatory capital ratios remain comfortably above well-capitalized thresholds, and the TCE ratio improved to 9.7% at quarter-end. Heritage Financial repurchased 372,000 shares totaling $10 million during Q2 FY26 and has 424,000 shares remaining under its current repurchase plan, indicating a continued focus on capital returns. The bank also executed a small investment portfolio loss trade, selling $38 million of securities at a $217,000 pretax loss to reinvest in higher-yielding assets, and noted significant upside from loan portfolio repricing and improving the loan-to-deposit ratio.