NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP DC

This section provides a comparative discussion of our consolidated results of operations between Q2 FY2024 and Q2 FY2023, and between YTD FY2024 and YTD FY2023. Following this section, we provide a discussion and analysis of material changes between amounts reported on our consolidated balance sheets as of November 30, 2023 and May 31, 2023. You should read these sections together with our “Executive Summary—Outlook” where we discuss trends and other factors that we expect will affect our future results of operations.

Net Interest Income

Net interest income, which is our largest source of revenue, represents the difference between the interest income earned on our interest-earning assets and the interest expense on our interest-bearing liabilities. Our net interest yield represents the difference between the yield on our interest-earning assets and the cost of our interest-bearing liabilities plus the impact of non-interest bearing funding. We expect net interest income and our net interest yield to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. We do not fund each individual loan with specific debt. Rather, we attempt to minimize costs and maximize efficiency by proportionately funding large aggregated amounts of loans.

Table 4 presents average balances for each major category of our interest-earning assets and interest-bearing liabilities, the interest income earned or interest expense incurred, and the average yield or cost. Table 4 also presents non-GAAP adjusted interest expense, adjusted net interest income and adjusted net interest yield, which reflect the inclusion of net accrued periodic derivative cash settlements expense in interest expense. We provide reconciliations of our non-GAAP financial measures to the most comparable U.S. GAAP financial measures under “Non-GAAP Financial Measures.”

Table 4: Average Balances, Interest Income/Interest Expense and Average Yield/Cost

(1)Interest income on long-term, fixed-rate loans includes loan conversion fees, which are generally deferred and recognized as interest income using the effective interest method.

(2)Consists of late payment fees and net amortization of deferred loan fees and loan origination costs.

(3)The average balance represents average monthly balances, which is calculated based on the month-end balance as of the beginning of the reporting period and the balances as of the end of each month included in the specified reporting period.

(4)Short-term borrowings reported on our consolidated balance sheets consist of borrowings with an original contractual maturity of one year or less. However, short-term borrowings presented in Table 2 consist of commercial paper, select notes, daily liquidity fund notes and secured borrowings under repurchase agreements. Short-term borrowings presented on our consolidated balance sheets related to medium-term notes, Farmer Mac notes payable and other notes payable are reported in the respective category for presentation purposes in Table 4. The period-end amounts reported as short-term borrowings on our consolidated balances sheets, which are excluded from the calculation of average short-term borrowings presented in Table 4, totaled $907 million and $398 million as of November 30, 2023 and 2022, respectively.

(5)Net interest spread represents the difference between the average yield on total average interest-earning assets and the average cost of total average interest-bearing liabilities. Adjusted net interest spread represents the difference between the average yield on total average interest-earning assets and the adjusted average cost of total average interest-bearing liabilities.

(6)Includes other liabilities and equity.

(7)Net interest yield is calculated based on annualized net interest income for the period divided by total average interest-earning assets for the period.

(8)Represents the impact of net periodic contractual interest amounts on our interest rate swaps during the period. This amount is added to interest expense to derive non-GAAP adjusted interest expense. The average (benefit)/cost associated with derivatives is calculated based on the annualized net periodic swap settlement interest amount during the period divided by the average outstanding notional amount of derivatives during the period. The average outstanding notional amount of interest rate swaps was $7,743 million and $7,753 million for Q2 FY2024 and Q2 FY2023, respectively. The average outstanding notional amount of interest rate swaps was $7,729 million and $7,864 million for the YTD FY2024 and YTD FY2023, respectively.

(9)Adjusted interest expense consists of interest expense plus net periodic derivative cash settlements interest income (expense) during the period. Net periodic derivative cash settlements interest income (expense) is reported on our consolidated statements of operations as a component of derivative gains (losses). Adjusted average cost is calculated based on annualized adjusted interest expense for the period divided by total average interest-bearing liabilities during the period.

(10)Adjusted net interest yield is calculated based on annualized adjusted net interest income for the period divided by total average interest-earning assets for the period.

Table 5 displays the change in net interest income between periods and the extent to which the variance for each category of interest-earning assets and interest-bearing liabilities is attributable to: (i) changes in volume, which represents the change in the average balances of our interest-earning assets and interest-bearing liabilities or volume and (ii) changes in the rate, which represents the change in the average interest rates of these assets and liabilities. The table also presents the change in adjusted net interest income between periods.

Table 5: Rate/Volume Analysis of Changes in Interest Income/Interest Expense

(1)The changes for each category of interest income and interest expense represent changes in either average balances (volume) or average rates for both interest-earning assets and interest-bearing liabilities. We allocate the amount attributable to the combined impact of volume and rate to the rate variance.

(2)For the net periodic derivative cash settlements interest amount, the variance due to average volume represents the change in the net periodic derivative cash settlements interest amount resulting from the change in the average notional amount of derivative contracts outstanding. The variance due to average rate represents the change in the net periodic derivative cash settlements amount resulting from the net difference between the average rate paid and the average rate received for interest rate swaps during the period.

(3)See “Non-GAAP Financial Measures” for additional information on our adjusted non-GAAP financial measures.

Reported Net Interest Income

Reported net interest income of $65 million for Q2 FY2024 decreased $14 million, or 17%, from Q2 FY2023, driven by a decrease in the net interest yield of 22 basis points, or 22%, to 0.77%, partially offset by an increase in average interest-earning assets of $2,105 million, or 7%.

•Average Interest-Earning Assets: The increase in average interest-earning assets of 7% was attributable to growth in average total loans of $2,162 million, or 7%, driven primarily by an increase in average long-term fixed-rate loans of $1,527 million and an increase in average line of credit loans of $558 million, as members continued to advance loans to fund capital expenditures and for working capital purposes.

•Net Interest Yield: The decrease in the net interest yield of 22 basis points, or 22%, was primarily attributable to the combined impact of an increase in our average cost of borrowings of 80 basis points to 4.11%, which was partially offset by an increase in the average yield on interest-earning assets of 53 basis points to 4.62% and an increase in the benefit from non-interest bearing funding of 5 basis points to 0.26%. Our average yield on interest-earning assets and average cost of borrowings rose mainly due to the sustained increase in the federal funds rate, which increased 150 basis points since November 30, 2022. The increase in average yields on line of credit and variable-rate loans was the primary driver for the increase in the average yield on interest-earning assets. Meanwhile, our average cost of borrowings increased due to higher interest rates on our short-term and variable-rate borrowings.

Reported net interest income of $130 million for YTD FY2024 decreased $46 million, or 26%, from YTD FY2023, driven by a decrease in the net interest yield of 35 basis points, or 31%, to 0.77%, partially offset by an increase in average interest-earning assets of $2,226 million, or 7%.

•Average Interest-Earning Assets: The increase in average interest-earning assets of 7% was attributable to growth in average total loans of $2,324 million, or 8%, driven primarily by an increase in average long-term fixed-rate loans of $1,441 million and an increase in average line of credit loans of $717 million, as members continued to advance loans to fund capital expenditures and for working capital purposes.

•Net Interest Yield: The decrease in the net interest yield of 35 basis points, or 31%, was primarily attributable to the combined impact of an increase in our average cost of borrowings of 99 basis points to 4.07%, which was partially offset by an increase in the average yield on interest-earning assets of 57 basis points to 4.57% and an increase in the benefit from non-interest bearing funding of 7 basis points to 0.27%. As mentioned above, the increases in the average cost of borrowings and average yield on interest-earning assets were driven by the continued increase in the federal funds rate.

Adjusted Net Interest Income

Adjusted net interest income of $94 million for Q2 FY2024 increased $10 million, or 12%, from Q2 FY2023, driven by the combined impact of an increase in average interest-earning assets of $2,105 million, or 7%, and an increase in the adjusted net interest yield of 7 basis points, or 7%, to 1.12%.

•Average Interest-Earning Assets: The increase in average interest-earning assets of 7% during Q2 FY2024 was driven by the growth in average total loans of $2,162 million, or 7%, attributable primarily to the increases in average long-term fixed-rate and line of credit loans as discussed above.

•Adjusted Net Interest Yield: The adjusted net interest yield increased to 1.12%, reflecting the combined impact of an increase in the average yield on interest-earning assets of 53 basis points to 4.62% and an increase in the benefit from non-interest bearing funding of 4 basis points to 0.25%, partially offset by an increase in our adjusted average cost of borrowings of 50 basis points to 3.75%, The increases in both average yield on interest-earning assets and adjusted average cost of borrowings were attributable to the continued high interest-rate environment since November 30, 2022, as discussed above.

Adjusted net interest income of $186 million for YTD FY2024 increased $16 million, or 10%, from YTD FY2023, driven by the combined impact of an increase in average interest-earning assets of $2,226 million, or 7%, and an increase in the adjusted net interest yield of 3 basis points, or 3%, to 1.11%.

•Average Interest-Earning Assets: The increase in average interest-earning assets of 7% during YTD FY2024 was driven by the growth in average total loans of $2,324 million, or 8%, attributable primarily to increases in average long-term fixed-rate and line of credit loans as discussed above.

•Adjusted Net Interest Yield: The increase in the adjusted net interest yield of 3 basis points, or 3%, reflected the combined impact of an increase in the average yield on interest-earning assets of 57 basis points to 4.57% and an increase in the benefit from non-interest bearing funding of 5 basis points to 0.25%, partially offset by an increase in our adjusted average cost of borrowings of 59 basis points to 3.71%. We discuss above the primary drivers for the increases in the

average yield on interest-earning assets and adjusted average cost of borrowings.

Derivative Cash Settlements

We include the net periodic derivative cash settlements interest income (expense) amounts on our interest rate swaps in the calculation of our adjusted average cost of borrowings, which, as a result, also impacts the calculation of adjusted net interest income and adjusted net interest yield. We recorded net periodic derivative cash settlements interest income of $29 million for Q2 FY2024, compared with $5 million for Q2 FY2023. We recorded net periodic derivative cash settlements interest income of $57 million for YTD FY2024, compared with derivative cash settlements interest expense of $6 million for YTD FY2023.

Following the cessation of LIBOR on June 30, 2023, daily compounded SOFR replaced LIBOR as the floating-rate index for our interest rate swaps. Because our derivative portfolio consists of a higher proportion of pay-fixed swaps than receive-fixed swaps, the net periodic derivative cash settlements interest income (expense) amounts generally change based on changes in the floating interest amount received each period. When floating rates increase during the period, the floating interest amounts received on our pay-fixed swaps increase and, conversely, when floating rates decrease, the floating interest amounts received on our pay-fixed swaps decrease. The higher floating rates during Q2 FY2024 and YTD FY2024 contributed to the derivative cash settlements interest income for the periods. In comparison, the lower floating rates during Q2 FY2023 and YTD FY2023 contributed to the lower derivative cash settlements income for Q2 FY2023 and derivative cash settlements interest expense for YTD FY2023.

See “Non-GAAP Financial Measures” for additional information on our non-GAAP financial measures, including a reconciliation of these measures to the most comparable U.S. GAAP financial measures.

Provision for Credit Losses

Our provision for credit losses each period is driven by changes in our measurement of lifetime expected credit losses for our loan portfolio recorded in the allowance for credit losses. Our allowance for credit losses and allowance coverage ratio was $56 million and 0.17%, respectively, as of November 30, 2023. In comparison, our allowance for credit losses and allowance coverage ratio was $53 million and 0.16%, respectively, as of May 31, 2023.

We recorded a provision for credit losses of $1 million for Q2 FY2024, resulted primarily from an increase inthe collective allowance due to loan portfolio growth. In comparison, we recorded a provision for credit losses of $12 million for Q2 FY2023, primarily driven byan increase in the asset-specific allowance for a nonperforming CFC power supply loan, attributable to a decrease in the expected payments on this loan.

We recorded a provision for credit losses of$1 million for YTD FY2024, compared to aprovision for credit losses of $15 million for YTD FY2023. The provision for credit losses for YTD FY2024 resulted from an increase of$4 million in the collective allowance, partially offset by a decrease of$1 million in the asset-specific allowance for a nonperforming CFC power supply loan and a recovery of $1 million attributable to additional loan payments received from Brazos Electric Power Cooperative, Inc. (“Brazos”) and its wholly-owned subsidiary Brazos Sandy Creek Electric Cooperative Inc. (“Brazos Sandy Creek”). The increase of$4 million in the collective allowance was primarily due to loan portfolio growth and a slight decline in the overall credit quality and risk profile of our loan portfolio. The provision for credit losses for the YTD FY2023 was driven primarily by an increase in the asset-specific allowance as discussed above.

We discuss our methodology for estimating the allowance for credit losses in “Note 1—Summary of Significant Accounting Policies—Allowance for Credit Losses—Current Methodology” in our 2023 Form 10-K. We also provide additional information on our allowance for credit losses below under section “Credit Risk—Allowance for Credit Losses” and “Note 5—Allowance for Credit Losses” in this Report.

Non-Interest Income

Non-interest income consists of fee and other income, gains and losses on derivatives not accounted for in hedge accounting relationships and gains and losses on equity and debt investment securities, which consists of both unrealized and realized gains and losses.

Table 6 presents the components of non-interest income (loss) recorded in our consolidated statements of operations.

Table 6: Non-Interest Income

The variance in non-interest income was primarily attributable to changes in the derivative gains recognized in our consolidated statements of operations. In addition, we experienced a favorable shift from losses to gains recorded on our debt and equity investment securities of $2 million and$9 millionfor Q2 FY2024 and YTD FY2024, respectively, compared with Q2 FY2023 and YTD FY2023. We expect period-to-period market fluctuations in the fair value of our equity and debt investment securities, which we report together with realized gains and losses from the sale of investment securities on our consolidated statements of operations.

Derivative Gains (Losses)

Our derivative instruments are an integral part of our interest rate risk management strategy. Our principal purpose in using derivatives is to manage our aggregate interest rate risk profile within prescribed risk parameters. The derivative instruments we use primarily include interest rate swaps, which we typically hold to maturity. In addition, we may use Treasury locks to manage the interest rate risk assoc iated with future debt issuance or debt that is scheduled to reprice in the future. The primary factors affecting the fair value of our derivatives and derivative gains (losses) recorded in our results of operations include changes in interest rates, the shape of the swap curve and the composition of our derivative portfolio. We generally do not designate our interest rate swaps, which currently account for all our derivatives, for hedge accounting. Accordingly, changes in the fair value of interest rate swaps are reported in our consolidated statements of operations under derivative gains (losses). However, if we execute a Treasury lock, we typically designate the Treasury lock as a cash flow hedge.

We currently use two types of interest rate swap agreements: (i) we pay a fixed rate of interest and receive a variable rate of interest (“pay-fixed swaps”), and (ii) we pay a variable rate of interest and receive a fixed rate of interest (“receive-fixed swaps”). The interest amounts are based on a specified notional balance, which is used for calculation purposes only. The benchmark variable rate for the floating-rate payments under our swap agreements is daily compounded SOFR as of November 30, 2023. As interest rates decline, pay-fixed swaps generally decrease in value and result in the recognition of derivative losses, as the amount of interest we pay remains fixed, while the amount of interest we receive declines. In contrast, asinterest rates rise, pay-fixed swaps generally increase in value and result in the recognition of derivative gains, as the amount of interest we pay remains fixed, but the amount we receive increases. With a receive-fixed swap, the opposite results occuras interest rates decline or rise. Our derivative portfolio consists of a higher proportion of pay-fixed swaps than receive-fixed swaps; therefore, we generally record derivative losses when interest rates decline and derivative gains when interest rates rise. Because our pay-fixed and receive-fixed swaps are referenced to different maturity terms along the swap curve, different changes in the swap curve—parallel, flattening, inversion or steepening—will also impact the fair value of our derivatives.

On November 3, 2023, we executed two Treasury lock agreements with an aggregate notional amount of $300 million to hedge interest rate risk by locking in the underlying U.S. Treasury interest rate component of interest rate payments on anticipated debt issuances. The Treasury locks were designated and qualified as cash flow hedges. On November 7, 2023, we terminated the Treasury locks upon the pricing of the $300 million of notes payable under our Farmer Mac revolving note purchase agreement and recorded a net settlement gain of less than $1 million in AOCI, which will be reclassified into interest expense over the term of the related Farmer Mac borrowings. We did not have any derivatives designated as accounting hedges as of November 30, 2023 and May 31, 2023.

Table 7 presents the components of net derivative gains (losses) recorded in our consolidated statements of operations. Derivative cash settlements interest income (expense) represents the net periodic contractual interest amount for our interest-rate swaps during the reporting period. Derivative forward value gains (losses) represent the change in fair value of our interest rate swaps during the applicable reporting period due to changes in expected future interest rates over the remaining life of our derivative contracts.

Table 7: Derivative Gains (Losses)

We recorded derivative gains of $107 million for Q2 FY2024, attributable to increases in the longer-term swap interest rates. In comparison, we recorded derivative gains of $147 million for Q2 FY2023, attributable to more pronounced increases in interest rates across the entire swap curve during the period.

We recorded derivative gains of $297 million for YTD FY2024, attributable to increases in the medium- and longer-term swap interest rates. In comparison, we recorded derivative gains of $240 million for YTD FY2023, attributable to increases in interest rates across the entire swap curve during the period.

Our derivatives portfolio consisted of interest rate swaps with a total notional amount of $7,621 million and $7,816 million as of November 30, 2023 and May 31, 2023, respectively. As discussed above, our derivative portfolio consists of a higher proportion of longer-dated pay-fixed swaps than receive-fixed swaps, with pay-fixed swaps accounting for approximately 78% of the outstanding notional amount of our derivative portfolio as of both November 30, 2023 and May 31, 2023. Therefore, increases and decreases in medium- and longer-term swap rates generally have a more pronounced corresponding impact on the change in the net fair value of our swap portfolio. The average remaining maturity of our pay-fixed and receive-fixed swaps was 18 years and two years, respectively, as of November 30, 2023 and 19 years and three years, respectively, as of November 30, 2022.

We present comparative swap curves, which depict the relationship between swap rates at varying maturities, for our reported periods in Table 8 below.

Comparative Swap Curves

Table 8 below provides comparative swap curves as of November 30, 2023, August 31, 2023, May 31, 2023, November 30, 2022 and May 31, 2022.

Table 8: Comparative Swap Curves

Benchmark rates obtained from Bloomberg.

See “Note 9—Derivative Instruments and Hedging Activities” for additional information on our derivative instruments. Also refer to “Note 14—Fair Value Measurement” to the Consolidated Financial Statements in our 2023 Form 10-K for information on how we measure the fair value of our derivative instruments.

Non-Interest Expense

Non-interest expense consists of salaries and employee benefit expense, general and administrative expenses, gains and losses on the early extinguishment of debt and other miscellaneous expenses. Table 9 presents the components of non-interest expense recorded in our consolidated statements of operations.

Table 9: Non-Interest Expense

Non-interest expense of $32 million and $64 million for Q2 FY2024 and YTD FY2024, respectively, increased $4 million, or 15% and $11 million, or 21%, respectively, from Q2 FY2023 and YTD FY2023, primarily attributable to an increase in operating expenses, driven by higher expenses reco rded for salaries, information technology, and depreciation and amortization expenses. During Q1 FY2024, we redeemed $100 million of our $400 million subordinated deferrable debt due 2043, at par plus accrued interest. As a result, we recognized $1 million of losses on early extinguishment of debt related to the unamortized debt issuance costs.

Net Income (Loss) Attributable to Noncontrolling Interests

Net income (loss) attributable to noncontrolling interests represents 100% of the results of operations of NCSC and RTFC, as the members of NCSC and RTFC own or control 100% of the interest in their respective companies. The fluctuations in net income (loss) attributable to noncontrolling interests are primarily due to changes in the fair value of NCSC’s derivative instruments recognized in NCSC’s earnings.

We recorded net loss attributable to noncontrolling interests of less than $1 million for Q2 FY2024 and net income of less than $1 million for YTD FY2024. In comparison, we recorded a net income attributable to noncontrolling interests of less than $1 million for both Q2 FY2023 and YTD FY2023.