# Territorial Bancorp: Higher Interest Rates Might Squeeze Earnings

## Summary

- TBNK's assets yield low long-term fixed rates while its liabilities yield variable rates.
- If interest rates were to increase, TBNK's income could get squeezed.
- Expected earnings yields are lackluster between 3.98% and 5.12%, with muted growth expectations.

**Introduction and Investment Thesis**

Territorial Bancorp Inc. (NASDAQ:TBNK) faces several risks ahead due to anticipated increases in interest rates. In general, their loans and investment securities are currently at very low long-term fixed rates, while their liabilities are floating. If interest rates were to spike, TBNK might get squeezed.

In the analysis below, we attempt to estimate a “normal” net income figure by considering TBNK’s revenue relative to its expenses; then determine how these normalized earnings compare to the stock’s current market price. Please note that all figures in blue come from the company’s SEC filings, and all figures in peach come from author calculations. All figures are in thousands, except per-share amounts and share quantities.

**Revenues**

TBNK earns revenues in two categories: interest income and noninterest income. Interest income makes up more than 86% of TBNK’s revenues, and is therefore the most important revenue category for TBNK’s financial performance:

*(Source: SEC Filings in blue; author calculations in peach)*

We discuss each of these two categories below.

**Interest Income**

TBNK earns interest on 3 types of assets: loans, investment securities, and other assets. The recent September 2021 10-Q had the following balances and yields for TBNK’s interest-earning assets for the Q3 2021 period:

*(Source: SEC Filings in blue; author calculations in peach)*

From the table above, we see that TBNK’s primary sources of revenue are its one-to-four family residential loans and its US government-sponsored mortgage-backed securities. Let’s look at each of these in turn.

### One-to-four Family Residential Loans

TBNK primarily offers 30-year fixed rate mortgages on one-to-four family residences. These types of loans generally earn lower yields than more risky types of loans (as can be seen in the table above). However, these types of loans also come with less risk of default/loss. In fact, we can see in the chart below that out of all the loans historically held by TBNK, they have lost less than 0.12% of each year’s loan balance over the past 10 years.

*(Source: SEC Filings in blue; author calculations in peach)*

The risk of such losses can generally be considered remote; especially when, as noted in their recent September 2021 10-Q, the current loan-to-value (i.e., tax assessed value) of all their loans is 45.2%, which pretty much guarantees the principal balances will be paid (either by the customer or by the sale of the collateral). To add to this, the current level of nonperforming assets is only $4.2 million (or 0.20% of outstanding loans), a negligible amount. As such, there is not much default risk in this portfolio, and we can be reasonably assured that the principal and interest on these loans will be collected.

Now let’s discuss the primary driver of interest income on the one-to-four family residential loans: interest rates. It’s a fairly common news story these days that interest rates will have to start rising soon. So what would be the effect of rising interest rates on TBNK’s residential loan portfolio (not taking into account the liability side of the balance sheet)? Probably not much. Unfortunately, TBNK is locked into the current fixed rates for several years ahead, possibly decades ahead. According to the recent 2020 10-K, 99.92% of TBNK’s one-to-four family residential loans mature in 2026 and beyond.

Investors/analysts typically anticipate positive results for banks when interest rates go up, presumably because any new loans can be underwritten at higher interest rates. But in TBNK’s case, I think an increase in interest rates would not materially affect their interest income. In taking the view that most homeowners have already refinanced at these low rates and that the recent flurry of homebuying is over (and that homeowners are less likely to refinance or buy a home when interest rates are higher), TBNK likely will not get to participate in higher rates for several years into the future. In that case, we might take the stance that current interest income on one-to-four family residential loans will remain constant for the next several years; in fact, TBNK’s loan portfolio has decreased by 17% in the past 4 years, as the company began selling the portfolio in favor of buying or securitizing mortgage-backed securities.

Having said that, let’s try to determine what a normal amount of interest income might be on the current loan portfolio. Based on the average yields (in the table above) and the loan balances as of September 30, 2021 (per the 10-Q), we might come up with a normal interest income of $47,290, calculated as follows:

*(Source: SEC Filings in blue; author calculations in peach)*

### Investment Securities

As noted above, TBNK primarily owns US government-sponsored mortgage-backed securities in its investment portfolio. When analyzing these securities, we are presented with the same benefits and risks as the one-to-four family residential mortgages discussed above. On the one hand, they are guaranteed by Freddie Mac or Fannie Mae, so our risk of default is negligible; but on the other hand, these are long-term “held to maturity” fixed rate investments at an extremely low yield. As we saw in the table above, these securities only yield 2.12%; and per the recent September 2021 10-Q, 99.99% of the securities will mature more than 10 years from now.

From this understanding, it seems TBNK is stuck with these securities for at least 10 years (especially since it has classified them as “held-to-maturity”). TBNK could, of course, sell them anyway; but if interest rates increase in the future, they would likely be sold for a loss as the value of the securities decreases when interest rates rise. Having said that, the classification as “held-to-maturity” for accounting purposes allows them to amortize the interest over the term of the securities, rather than adjusting them to fair value at each period end. This would allow a consistent annual interest income presented in the income statement over the term of the securities.

With this insight, let’s try to determine what a normal amount of interest income might be on the current securities portfolio. Based on the average yield of 2.12% and the investment balance of $621,417 as of September 30, 2021 (per the 10-Q), we might expect a normal interest income of $13,174 going forward.

Other sources of interest income include approximately $700 related to other loan types; we exclude those from our analysis for brevity.

**Non-Interest Income**

Even though non-interest income has only represented 8% of revenues on average over the past 10 years, I think it’s important to look deeper into these, because I feel they might have been skewed in recent years with realized investment gains that might not be recurring. Over the past 10 years, non-interest income has been composed of the following types of transactions:

*(Source: SEC Filings in blue; author calculations in peach)*

If we stand by our thought process that interest rates might go up, we should also make the assumption that the values of the investment securities and loans might go down in response; in that case, we might not expect gains on these securities going forward. In fact, since the investment securities are held-to-maturity anyway, they are not likely to be sold (unless they’ve reached 85% of their term, per accounting rules); but remembering that the maturity dates are 10+ years out, if interest rates were to rise, they would be sitting at a substantial loss position 8.5 years from now (especially given their sizable duration). Same goes for the loans; if they are sitting at a loss, management is not likely to sell them, unless they have prospects to loan these funds out at higher rates, which could possibly be the case in the future.

All this to say, for purposes of normalizing earnings, we might conclude that the best estimate of future non-interest income might be the Q1-Q3 2021 annualized non-interest income excluding gains on investment securities and loans (as we don’t expect gains in the future); this results in an expectation of $3,687 in non-interest income going forward.

**Expenses**

TBNK’s expenses are composed of interest expense and non-interest expense:

*(Source: SEC Filings in blue; author calculations in **peach)*

### Non-interest Expense

Non-interest expense makes up the majority of expenses; but since it is mostly a fixed cost, we make less effort in estimating a normal amount. We see that the non-interest expense has been creeping up each year, somewhat in line with the increase in number of locations and the size of the loan portfolio. This would make sense as more administrative expenses would be required as the company grows. Given that understanding, our best guess for “normal” non-interest expense is likely to be the Q1-Q3 2021 annualized amount, which is $38,307.

Next, we dive a little deeper into the more variable and risky of the two expense types: interest expense.

### Interest Expense

The liability side of the balance sheet gives us insight into the interest expense of the company. The recent September 2021 10-Q had the following balances and yields for TBNK’s interest-earning liabilities for the Q3 2021 period:

*(Source: SEC Filings in blue; author calculations in peach)*

As we can see from the table above, deposit accounts are certainly the cheapest sources of capital (especially savings and checking accounts), while FHLB advances and repurchase agreements are the most expensive. So the bank would obviously prefer to source its capital from depositors, which has proven to be the case: over the past 10 years, TBNK has continued to increase its deposits, while not needing to rely so much on other more expensive sources of capital; although the past 4 years haven’t seen much growth in deposits:

*(Source: SEC Filings in blue; author calculations in peach)*

If we were to try to estimate what interest expense to expect today, we would merely multiply the current yields by the current balances, resulting in $5,632:

*(Source: SEC Filings in blue; author calculations in peach)*

This amount is less than half of the 2020 interest expense and significantly less than the average amount over the past 10 years. This is because the deposit mix in 2021 has leaned more heavily on checking/savings accounts than on CDs, so TBNK pays less in interest. In fact, the deposit mix is at an all-time low percentage for CDs currently.

*(Source: SEC Filings in blue; author calculations in peach)*

Looking at the table above, we see that the deposit mix for the various categories is within the range of the past 10 years, so I don’t feel the current deposit mix is an anomaly; and perhaps we can rely on the current mix going forward. If we can consider the current mix “normal”, I think we can rely on a “normal” interest expense of $5,632 (calculated earlier) based on the current deposit mix and balances. But of course, interest rates could possibly increase in the future; let’s address that now.

To get an idea of what each of the deposit account types might yield at various interest rate levels, let’s look back at the yields on the company’s deposit accounts compared to the federal funds rate throughout the company’s history. The table below shows the average yields of each deposit account type over the past 10 years, compared to the average federal funds rate at that time:

*(Source: SEC Filings in blue; author calculations in peach)*

As we can see, the rates vary in line with the federal funds rate over time; although a higher federal funds rate tends to result in a higher yield multiple than lower federal funds rates. Per the recent September 2021 FOMC Meeting, the economic projections of the Federal Reserve Board members and Federal Reserve Bank presidents are as follows:

*(Source: September 2021 FOMC Projections materials)*

Based on these projections, we might expect a gradual increase to 2.50% federal funds rate over the long term; as such, since our historical data covers federal funds rates up to 2.16%, I think the 10-year history is sufficient for our purposes. So to estimate/project TBNK’s interest expense under various interest rate regimes, let’s take the current deposit mix and balances and estimate what amount of interest TBNK might incur at various levels of federal funds rates. As we can see in the table below, the expected interest expense for TBNK (under the current deposit mix and balances) would likely fall between $6,342 and $10,184 in a range of federal funds rates between 0.10% and 2.50%.

*(Source: SEC Filings in blue; author calculations in peach)*

**Profitability**

Based on the analysis above, we can attempt to normalize the profitability of TBNK (i.e., what its profit might be in a “normal” year over the long term). To do so, we will take into account our discussions above to come to appropriate amounts of revenues and expenses:

- Interest Income: As noted above, an appropriate long-term interest income amount might be $60,464, which is $47,290 one-to-four family residential loans and $13,174 interest on investment securities.
- Non-interest Income: As noted above, an appropriate long-term non-interest income might be $3,687, which is the Q1-Q3 2021 annualized non-interest income excluding gains on investment securities and loans.
- Provision for Loan Losses: As previously discussed, we expect loan losses to be negligible, and expect this long-term amount to be materially $0.
- Non-interest expense: As noted above, we have determined a normal non-interest expense amount to be $38,307, which is the Q1-Q3 2021 annualized amount.
- Interest Expense: As discussed above, we expect a “normal” interest expense on deposits to be between $6,342 and $10,184, depending on future interest rate changes. The interest rates on the GHLB loan and the repurchase agreements would be their respective balances of $141,000 and $10,000, multiplied by their respective yields of 1.48% and 1.84%; this comes to $2,086.80 and $184, respectively. In total, interest expense would be between $8,613 and $12,455 under federal funds rate regimes between 0.10% and 2.50%.

Since we have a range here, let’s put this into a table so that we can see the range of net income we might expect based on these assumptions:

*(Source: SEC Filings in blue; author calculations in peach)*

Based on the table above, we might expect a net income of between $9,774 and $12,578, based on a range of expected interest rate regimes. With that in mind, let’s consider how this looks in relation to the stock’s price.

**Valuation**

As of 12/02/2021, TBNK’s stock was trading at $26.35 per share; and across 9,324,060 shares outstanding as of October 31, 2021, this results in a market capitalization of $245.689 million. Using our calculated net income range above, we come to an earnings yield between 3.98% and 5.12% (i.e., a P/E between 19.53 and 25.14), based on a range of anticipated federal funds rates:

*(Source: SEC Filings in blue; author calculations in peach)*

For growth companies, we might be comfortable with such low earnings yields, as we would expect earnings to increase. But based on our analysis above, we would more likely expect earnings to decrease in the future as interest rates rise. This is primarily because TBNK is locked into its long-term fixed rate loans and investment securities, while its deposit accounts float with changes in interest rates. As we mentioned previously, we don’t expect the company’s assets to materially grow going forward, because the market for refinancing or home purchases is likely to decline as interest rates rise. In addition, over the past several years, TBNK has been paying more than $10,000 in dividends each year; if earnings drop to the levels we have calculated above, this annual dividend starts to be in jeopardy.

Considering all of this analysis, I believe the current price is too expensive for the risks we’ve discussed. I would be a bit more comfortable if the company’s assets were at variable rates; or if the company allowed hedging to swap their fixed rates to variable; or if there were expectations that the company’s portfolio would grow as interest rates rise. But as it is, I feel like they will be trapped in their assets’ currently low yields for decades to come, while the liability side slowly squeezes them.

This article was written by

**Disclosure:** I/we have a beneficial long position in the shares of TBNK either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.