NATIONAL RURAL UTILITIES COOPERATIVE FINANCE CORP DC

This section provides a comparative discussion of our consolidated results of operations between Q3 FY2024 and Q3 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 February 29, 2024 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 3 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 3 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 and Reconciliations.”

Table 3: 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 3 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 3. 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 3, totaled $982 million and $853 million as of February 29, 2024 and February 28, 2023, 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 $7,568 million and $7,555 million for Q3 FY2024 and Q3 FY2023, respectively. The average outstanding notional amount of interest rate swaps was $7,675 million and $7,762 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 4 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 4: 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 and Reconciliations” for additional information on our adjusted non-GAAP financial measures.

Reported Net Interest Income

Reported net interest income of $65 million for Q3 FY2024 decreased $7 million, or 9%, from Q3 FY2023, driven by a decrease in the net interest yield of 14 basis points, or 16%, to 0.74%, partially offset by an increase in average interest-earning assets of $2,266 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 $2,188 million, or 7%, driven primarily by an increase in average long-term fixed-rate loans of $1,848 million and an increase in average line of credit loans of $397 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 14 basis points, or 16%, was primarily attributable to the combined impact of an increase in our average cost of borrowings of 53 basis points to 4.24%, which was partially offset by an increase in the average yield on interest-earning assets of 36 basis points to 4.71% and an increase in the benefit from non-interest bearing funding of 3 basis points to 0.27%. 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 75 basis points since February 28, 2023. 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 $195 million for YTD FY2024 decreased $53 million, or 21%, from YTD FY2023, driven by a decrease in the net interest yield of 28 basis points, or 27%, to 0.76%, partially offset by an increase in average interest-earning assets of $2,243 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 $2,282 million, or 7%, driven primarily by an increase in average long-term fixed-rate loans of $1,578 million and an increase in average line of credit loans of $612 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 28 basis points, or 27%, was primarily attributable to the combined impact of an increase in our average cost of borrowings of 83 basis points to 4.13%, which was partially offset by an increase in the average yield on interest-earning assets of 50 basis points to 4.62% and an increase in the benefit from non-interest bearing funding of 5 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 $103 million for Q3 FY2024 increased $13 million, or 14%, from Q3 FY2023, driven by the combined impact of an increase in average interest-earning assets of $2,266 million, or 7%, and an increase in the adjusted net interest yield of 7 basis points, or 6%, to 1.18%.

•Average Interest-Earning Assets: The increase in average interest-earning assets of 7% during Q3 FY2024 was driven by the growth in average total loans of $2,188 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 1.18%, reflecting the combined impact of an increase in the average yield on interest-earning assets of 36 basis points to 4.71% and an increase in the benefit from non-interest bearing funding of 2 basis points to 0.24%, partially offset by an increase in our adjusted average cost of borrowings of 31 basis points to 3.77%. 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 February 28, 2023, as discussed above.

Adjusted net interest income of $290 million for YTD FY2024 increased $29 million, or 11%, from YTD FY2023, driven by the combined impact of an increase in average interest-earning assets of $2,243 million, or 7%, and an increase in the adjusted net interest yield of 4 basis points, or 4%, to 1.13%.

•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 $2,282 million, or 7%, 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 4 basis points, or 4%, reflected the combined impact of an increase in the average yield on interest-earning assets of 50 basis points to 4.62% and an increase in the benefit from non-interest bearing funding of 3 basis points to 0.24%, partially offset by an increase in our adjusted average cost of borrowings of 49 basis points to 3.73%. 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. 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. We recorded net periodic derivative cash settlements interest income of $38 million for Q3 FY2024 compared with $19 million for Q3 FY2023, andnet periodic derivative cash settlements interest income of $95 million for YTD FY2024 compared with $13 million for YTD FY2023. The increases inderivative cash settlements interest income were due to thehigher floating rates in Q3 FY2024 and YTD FY2024, compared to Q3 FY2023 and YTD FY2023, respectively.

See “Non-GAAP Financial Measures and Reconciliations” 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 $49 million and 0.14%, respectively, as of February 29, 2024. 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 benefit for credit losses of $6 million and$11 millionfor Q3 FY2024 and Q3 FY2023, respectively, primarily from reductions in the asset-specific allowances for a nonperforming CFC power supply loan attributable to increases in the expected payments on the loan for both periods.

We recorded a benefit for credit losses of$5 million for YTD FY2024, resulting from a decrease of$8 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”), partially offset by an increase of$4 million in the collective allowance due to loan portfolio growth and a slight decline in the overall credit quality and risk profile of our loan portfolio.

We recorded a provision for credit losses of $4 million for YTD FY2023, driven primarily by increases in the collective allowance, primarily due to loan portfolio growth, and in the asset-specific allowance for loans to Brazos, Brazos Sandy Creek, and for a nonperforming CFC power supply loan.

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 (Loss)

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

Table 5: Non-Interest Income (Loss)

The variance in non-interest income was primarily attributable to changes in the derivative gains (losses) 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 $6 million and $14 million for Q3 FY2024 and YTD FY2024, respectively, compared with Q3 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)

As of February 29, 2024 and May 31, 2023, our derivatives portfolio included interest rate swap agreements not designated for hedge accounting, comprised of pay-fixed swaps and receive-fixed swaps, with the benchmark variable rate for the floating rate payments based on daily compounded SOFR as of February 29, 2024. Additionally, Treasury locks may be used to manage the interest rate risk assoc iated with future debt issuance or repricing and are typically designated as cash flow hedges.

The total notional amount for our interest rate swaps was $7,345 million and $7,816 million as of February 29, 2024 and May 31, 2023, respectively. The portfolio was primarily composed of longer-dated pay-fixed swaps, which accounted for approximately 81% and 78% of the outstanding notional amount as of February 29, 2024 and May 31, 2023, respectively. Consequently, changes in medium- and longer-term swap rates generally have a more pronounced impact on the net fair value of our swap portfolio. As of February 29, 2024, the average remaining maturity of our pay-fixed and receive-fixed swaps was 18 years and two years, respectively, compared to 19 years and three years, respectively, as of February 28, 2023.

Table 6 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 6: Derivative Gains (Losses)

We recorded derivative losses of $18 million for Q3 FY2024, primarily attributable to decreases in interest rates across the entire swap curve during Q3 FY2024. In comparison, we recorded derivative gains of $102 million for Q3 FY2023, attributable to increases in interest rates across the entire swap curve during the period.

We recorded derivative gains of $278 million for YTD FY2024, primarily attributable to increases in the medium- and longer-term swap interest rates during YTD FY2024. In comparison, we recorded derivative gains of $343 million for YTD FY2023, attributable to more pronounced increases in interest rates across the entire swap curve during the period.

In January 2023, we executed two Treasury lock agreements with an aggregate notional amount of $300 million to hedge interest rate risk on anticipated debt issuances. The agreements, which were scheduled to mature on December 2023, were designated as a cash flow hedge of a forecasted transaction. In February 2023, we terminated the Treasury locks and recorded a settlement gain of $8 million in AOCI. As the hedged forecasted transaction did not occur in the time period specified in the hedge documentation, we reclassified the $8 million gain from AOCI to earnings as a component of derivative gains (losses) on our consolidated statements of operations during Q3 FY2024.

We present comparative swap curves, which depict the relationship between swap rates at varying maturities, for our reported periods in Table 7 below.

Comparative Swap Curves

Table 7 below provides comparative swap curves as of February 29, 2024, November 30, 2023, May 31, 2023, February 28, 2023, November 30, 2022, and May 31, 2022.

Table 7: 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 8 presents the components of non-interest expense recorded in our consolidated statements of operations.

Table 8: Non-Interest Expense

Non-interest expense of $30 million and $95 million for Q3 FY2024 and YTD FY2024, respectively, increased $5 million, or 18% and $16 million, or 20%, respectively, from Q3 FY2023 and YTD FY2023, primarily attributable to an increase in operating expenses, driven by higher expenses reco rded for salaries and benefits, information technology, and depreciation and amortization expenses. During the three months ended August 31, 2023 (“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. On December 1, 2023, RTFC completed the sale of its business to NCSC and subsequently CFC concluded that it is no longer the primary beneficiary of RTFC and accordingly, deconsolidated RTFC from its consolidated financial statements. 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 both Q3 FY2024 and YTD FY2024. In comparison, we recorded net income attributable to noncontrolling interests of less than $1 million and $1 million for Q3 FY2023 and YTD FY2023, respectively.