This Quarterly Report on Form 10-Q (this “Report”) contains certain statements that are considered “forward-looking statements” within the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity” and similar expressions, whether in the negative or affirmative. All statements about future expectations or projections, including statements about loan volume, the appropriateness of the allowance for loan losses, operating income and expenses, leverage and debt-to-equity ratios, borrower financial performance, impaired loans, and sources and uses of liquidity, are forward-looking statements. Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, actual results and performance may differ materially from our forward-looking statements due to several factors. Factors that could cause future results to vary from our forward-looking statements include, but are not limited to, general economic conditions, legislative changes including those that could affect our tax status, governmental monetary and fiscal policies, demand for our loan products, lending competition, changes in the quality or composition of our loan portfolio, changes in our ability to access external financing, changes in the credit ratings on our debt, valuation of collateral supporting impaired loans, charges associated with our operation or disposition of foreclosed assets, technological changes within the rural electric utility industry, regulatory and economic conditions in the rural electric industry, nonperformance of counterparties to our derivative agreements, the costs and effects of legal or governmental proceedings involving us or our members and the factors listed and described under “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended May 31, 2019 (“2019 Form 10-K”). Except as required by law, we undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date on which the statement is made.

National Rural Utilities Cooperative Finance Corporation (“CFC”) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC’s principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service (“RUS”) of the United States Department of Agriculture (“USDA”). CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution systems, generation and transmission (“power supply”) systems and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes under Section 501(c)(4) of the Internal Revenue Code. As a member-owned cooperative, CFC’s objective is not to maximize profit, but rather to offer members cost-based financial products and services. CFC funds its activities primarily through a combination of public and private issuances of debt securities, member investments and retained equity. As a Section 501(c)(4) tax-exempt, member-owned cooperative, we cannot issue equity securities.

Our financial statements include the consolidated accounts of CFC, National Cooperative Services Corporation (“NCSC”), Rural Telephone Finance Cooperative (“RTFC”) and subsidiaries created and controlled by CFC to hold foreclosed assets resulting from defaulted loans or bankruptcy. NCSC is a taxable member-owned cooperative that may provide financing to members of CFC, government or quasi-government entities which own electric utility systems that meet the Rural Electrification Act definition of “rural” and for-profit and nonprofit entities that are owned, operated or controlled by, or provide significant benefits to certain members of CFC. RTFC is a taxable Subchapter T cooperative association that provides financing for its rural telecommunications members and their affiliates. CFC didand its consolidated entities have not hold, and did not haveheld any subsidiaries or other entities that held, foreclosed assets as ofsince the quarter ended August 31, 2019 or May 31, 2019.2017. See “Item 1. Business—Overview” in our 2019 Form 10-K for additional information on the business activities of each of these entities. Unless stated otherwise, references to “we,” “our” or “us” relate to CFC and its consolidated entities. All references to members within this document include members, associates and affiliates of CFC and its consolidated entities.

Our principal operations are organized for management reporting purposes into three business segments: CFC, NCSC and RTFC. Loans to members totaled $26,300$26,438 million as of August 31,November 30, 2019, of which 96% was attributable to CFC. We generated total revenue, which consists of net interest income and fee and other income, of $88$171 million for the threesix months ended August 31,November 30, 2019, (“current quarter”), compared with $72$153 million for the same prior-year period. The substantial majority of our total revenue is attributable to CFC. We provide information on the financial performance of each of our business segments in “Note 13—Business Segments.”

Management monitors a variety of key indicators to evaluate our business performance. The following MD&A is intended to provide the reader with an understanding of our consolidated results of operations, financial condition and liquidity by discussing the factors influencing changes from period to period and the key measures used by management to evaluate performance, such as net interest income, net interest yield, loan growth, debt-to-equity ratio, credit quality metrics and also non-GAAP measures. The MD&A section is provided as a supplement to, and should be read in conjunction with our unaudited condensed consolidated financial statements and related notes in this Report, our audited consolidated financial statements and related notes in our 2019 Form 10-K and additional information contained in our 2019 Form 10-K, including the risk factors discussed under “Part I—Item 1A. Risk Factors,” as well as any risk factors identified under “Part II—Item 1A. Risk Factors” in this Report.

Table 1 provides a summary of consolidated selected financial data for the three and six months ended August 31,November 30, 2019 and 2018, and as of August 31,November 30, 2019 and May 31, 2019. In addition to financial measures determined in accordance with generally accepted accounting principles in the United States (“GAAP”), management also evaluates performance based on certain non-GAAP measures and metrics, which we refer to as “adjusted” measures. Certain financial covenant provisions in our credit agreements are also based on non-GAAP financial measures. Our key non-GAAP financial measures are adjusted net income, adjusted net interest income, adjusted interest expense, adjusted net interest yield, adjusted times interest earned ratio (“adjusted TIER”) and adjusted debt-to-equity ratio. The most comparable GAAP measures are net income, net interest income, interest expense, net interest yield, TIER and debt-to-equity ratio, respectively. The primary adjustments we make to calculate these non-GAAP measures consist of (i) adjusting interest expense and net interest income to include the impact of net periodic derivative cash settlements expense; (ii) adjusting net income, total liabilities and total equity to exclude the non-cash impact of the accounting for derivative financial instruments; (iii) adjusting total liabilities to exclude the amount that funds CFC member loans guaranteed by RUS, subordinated deferrable debt and members’ subordinated certificates; and (iv) adjusting total equity to include subordinated deferrable debt and members’ subordinated certificates and exclude cumulative derivative forward value gains and losses and accumulated other comprehensive income (“AOCI”). We believe our non-GAAP adjusted measures, which are not a substitute for GAAP and may not be consistent with similarly titled non-GAAP measures used by other companies, provide meaningful information and are useful to investors because management evaluates performance based on these metrics, and certain financial covenants in our committed bank revolving line of credit agreements and debt indentures are based on adjusted measures. See “Non-GAAP Financial Measures” for a detailed reconciliation of these adjusted measures to the most comparable GAAP measures.

Our primary objective as a member-owned cooperative lender is to provide cost-based financial products to our rural electric members while maintaining a sound financial position required for investment-grade credit ratings on our debt instruments. Our objective is not to maximize profit; therefore, the rates we charge our member-borrowers reflect our funding costs plus a spread to cover our operating expenses, a provision for loan losses and earnings sufficient to achieve interest coverage to meet our financial objectives. Our goal is to earn an annual minimum adjusted TIER of 1.10 and to maintain an adjusted debt-to-equity ratio at approximately or below 6.00-to-1.

We are subject to period-to-period volatility in our reported GAAP results due to changes in market conditions and differences in the way our financial assets and liabilities are accounted for under GAAP. Our financial assets and liabilities expose us to interest-rate risk. We use derivatives, primarily interest rate swaps, as part of our strategy in managing this risk. Our derivatives are intended to economically hedge and manage the interest-rate sensitivity mismatch between our financial assets and liabilities. We are required under GAAP to carry derivatives at fair value on our consolidated balance sheet; however, the financial assets and liabilities for which we use derivatives to economically hedge are carried at amortized cost. Changes in interest rates and the shape of the swap curve result in periodic fluctuations in the fair value of our derivatives, which may cause volatility in our earnings because we do not apply hedge accounting for our interest rate swaps. As a result, the mark-to-market changes in our interest rate swaps are recorded in earnings. Because our derivative portfolio consists of a higher proportion of pay-fixed swaps than receive-fixed swaps, we generally record derivative losses when interest rates decline and derivative gains when interest rates rise. This earnings volatility generally is not indicative of the underlying economics of our business, as the derivative forward fair value gains or losses recorded each period may or may not be realized over time, depending on the terms of our derivative instruments and future changes in market conditions that impact the periodic cash settlement amounts of our interest rate swaps. As such, management uses our adjusted non-GAAP results to evaluate our operating performance. Our adjusted results include realized net periodic interest rate swap settlement amounts but exclude the impact of unrealized forward fair value gains and losses. Our financial debt covenants are also based on our non-GAAP adjusted results, as the forward fair value gains and losses related to our interest rate swaps do not affect our cash flows, liquidity or ability to service our debt.

The variance of $372$122 million between our reported net lossincome of $324$242 million for the current quarter and our reported net income of $48$120 million for the same prior-year quarter was driven by an increase in derivative gains of $120 million. We recorded derivative gains of $183 million for the current quarter, compared with derivative gains of $63 million for the same prior-year quarter. The derivative gains in both periods were primarily attributable to an increase in the fair value of our pay-fixed swaps due to increases in medium- and long-term swap rates during each period. The rise in medium- and long-term interest rates, however, was more pronounced during the current quarter relative to the same prior-year quarter, resulting in significantly higher derivative gains. Net interest income, which accounted for 95% and 96% of total revenue for both the current quarter and same prior-year quarter, increased by $2 million, or 3%, to $79 million. The increase was attributable to an increase in our average interest-earning assets of $1,121 million, or 4%, which was partially offset by a decrease in the net interest yield of 2 basis points, or 2%, to 1.17%.

The variance of $250 million between our reported net loss of $82 million for the six months ended November 30, 2019, and our reported net income of $168 million for the same prior-year period was driven by an unfavorable shift in derivative fair value changes of $403$283 million. We recorded derivative losses of $396$212 million duringfor the current quarter,six months ended November 30, 2019, largely due to decreasesa decrease in the fair value of our pay-fixed swaps resulting from a decline in interest rates across the swap curve, with medium- and longer-term interest rates experiencing a steeper decline than short-term rates. The swap curve remained inverted, as short-term interest rates continued to exceed medium- and longer-term interest rates as of the end of the current quarter.curve. In comparison, we recorded derivative gains of $7$71 million during the comparable prior-year quarterperiod due to a netan increase in the fair value of our pay-fixed swaps resulting from a slight rise in medium and longer-term interest rates.rates across the swap yield curve. Net interest income, which represented 88%accounted for 91% and 95% of total revenue for both the current quartersix months ended November 30, 2019 and same prior-year quarter,2018, respectively, increased $8$11 million, or 12%7%, to $156 million. The increase was attributable to the combined impact of an increase in average interest-earning assets of $976 million, or 4%, and an increase in the net interest yield of 104 basis points, or 10%4%, to 1.14%, and an increase in our average interest-earning assets of $833 million, or 3%1.16%. The increase in the net interest yield reflected the combined impact of an increase in the average yield on interest-earning assets of 5 basis pointswas due to 4.30% and a reduction in our average cost of funds of 45 basis points to 3.36%3.32%, which was partially offset by a slight decrease in the average yield on interest-earning assets of 1 basis point to 4.28%. The decrease in our average cost of funds was largely due toreflects the impact of the interest savings from the repayment of the 10.375% collateral trust bonds in the first half of fiscal year 2019 and the replacement of this

Other factors affecting the variance between our current quarter results for the six months ended November 30, 2019 and the comparable prior-year quarterperiod include an increase in fee income of $7 million due to higher prepayment fees, during the current quarter, a gain of $8 million recorded in connection with the July 22, 2019 sale of land and the absence of the loss of $7 million on the early redemption of $300 million of 10.375% collateral trust bonds recorded in the same prior-year quarter.period.

Loans to members totaled $26,300$26,438 million as of August 31,November 30, 2019, an increase of $383$521 million, or 1%2%, from May 31, 2019. CFC distribution loans, CFC power supply loans and RTFC loans increased by $329 million, $92 million and $6 million, respectively, which was partially offset by a decrease in NCSC loans of $45 million. The increase in loans was driven by a net increase in long-term loans of $479$631 million, which was partially offset by a net decrease in revolving line-of-credit loans of $96$110 million. CFC distribution loans, CFC power supply loans and RTFC loans increased by $527 million, $23 million and $11 million, respectively, while NCSC loans decreased by $41 million.

Long-term loan advances totaled $888$1,387 million during the current quarter,six months ended November 30, 2019, with approximately 73%69% of those advances for capital expenditures by members and 19%25% for the refinancing of loans made by other lenders. In comparison, long-term loan advances totaled $468$814 million during the same prior-year quarter,period, with approximately 71%83% of those advances for capital expenditures and 25%14% for the refinancing of loans made by other lenders. CFC had long-term fixed-rate loans totaling $110$234 million that were scheduled to reprice during the current quarter.six months ended November 30, 2019. Of this total, $109$224 million repriced to a new long-term fixed rate, $7 million repriced to a long-term variable rate and $1$3 million was repaid in full. In comparison, CFC had long-term fixed-rate loans totaling $193$439 million that were scheduled to reprice during the same prior-year quarter,period, of which $96$296 million repriced to a new long-term fixed rate, $48$88 million repriced to a long-term variable rate and $49$55 million was repaid in full.

The overall credit quality of our loan portfolio remained high as of August 31,November 30, 2019, as evidenced by our continued strong credit performance metrics. We had no delinquent or nonperforming loans as of August 31,November 30, 2019, and we have not experienced any loan defaults or charge-offs since fiscal year 2017. Outstanding loans to electric utility organizations represented approximately 99% of total outstanding loan portfolio as of August 31,November 30, 2019, unchanged from May 31, 2019. We historically have had limited defaults and losses on loans in our electric utility loan portfolio. We generally lend to members on a senior secured basis, which reduces the risk of loss in the event of a borrower default. Of our total loans

We issue debt primarily to fund growth in our loan portfolio. As such, our outstanding debt volume generally increases and decreases in response to member loan demand. Total debt outstanding increased by $303$403 million, or 1%2%, to $25,464$25,565 million as of August 31,November 30, 2019, from May 31, 2019, due to an increase in borrowings to fund the increase in loans to members. The increase was primarily attributable to a net increase in member commercial paper, select notes and daily liquidity fund notes totaling $519$916 million, which was partially offset by a net decreaseincrease in dealer commercial paper outstanding of $115$94 million and a net decreaseincrease in Federal Agricultural Mortgage Corporation (“Farmer Mac”) notes payable of $92$40 million. These increases were partially offset by a net decrease in medium-term notes of $296 million, a net decrease in collateral trust bonds of $297 million and a net decrease in borrowings under USDA’s Guaranteed Underwriter Program (“Guaranteed Underwriter Program”) of $23$47 million. Outstanding dealer commercial paper totaled $830$1,039 million as of August 31,November 30, 2019, below our targeted maximum threshold of $1,250 million.

amount under the amended three-year and five-year bank revolving line of credit agreements is $1,315 million and $1,410 million, respectively, resulting in a combined total commitment amount under the two facilities of $2,725 million.

We currently expect that our net interest income, adjusted net interest income, tier, adjusted tier, net interest yield and adjusted net interest yield will increase slightly over the next 12 months, largely due to a projected decrease in our average cost of funds and an increase in average interest-earning assets.

Long-termThe face value of long-term debt scheduled to mature over the next 12 months totaled $2,218$1,772 million as of August 31,November 30, 2019, consisting of $2,071$1,624 million of fixed-rate debt atwith a weighted average cost of 2.35%2.45% and $147$148 million of variable-rate debt. We believe we have sufficient liquidity from the combination of existing cash and cash equivalents, member loan repayments, committed bank revolving lines of credit, committed loan facilities under the Guaranteed Underwriter Program, revolving note purchase agreements with Farmer Mac and our ability to issue debt in the capital markets, to our members and in private placements, to meet the demand for member loan advances and satisfy our obligations to repay long-term debt maturing over the next 12 months. As of August 31,November 30, 2019, sources of liquidity readily available for access totaled $7,091$6,591 million, consisting of (i) $231$114 million in cash and cash equivalents; (ii) up to $1,350 million available under committed loan facilities under the Guaranteed Underwriter Program; (iii) up to $2,972$2,722 million available for access under committed bank revolving line of credit agreements; (iv) up to $2,238$2,255 million available under a revolving note purchase agreement with Farmer Mac, subject to market conditions; and (v) up to $300$150 million available under a committed revolving note purchase agreement with Farmer Mac. On September 25, 2019, we received a commitment letter for the guarantee by RUS of a $500 million loan facility from the Federal Financing Bank under the Guaranteed Underwriter Program.

We believe we can continue to roll over outstanding member short-term debt of $3,198$3,600 million as of August 31,November 30, 2019, based on our expectation that our members will continue to reinvest their excess cash in our commercial paper, daily liquidity fund notes, select notes and medium-term notes. We expect to continue accessing the dealer commercial paper market as a cost-effective means of satisfying our short-term liquidity needs. Although the intra-period amount of outstanding dealer commercial paper may fluctuate based on our liquidity requirements, we intend to manage our short-term wholesale funding risk by maintaining outstanding dealer commercial paper at an amount near or below $1,250 million for the foreseeable future. We expect to continue to be in compliance with the covenants under our committed bank revolving line of credit agreements, which will allow us to mitigate roll-over risk, as we can draw on these facilities to repay dealer or member commercial paper that cannot be refinanced with similar debt.

While we are not subject to bank regulatory capital rules, we generally aim to maintain an adjusted debt-to-equity ratio at approximately or below 6.00-to-1. Our adjusted debt-to-equity ratio was 5.845.78 as of August 31,November 30, 2019, below our targeted threshold. Based on our projection of loan advances and adjusted equity over the next 12 months, we anticipate that our adjusted debt-to-equity ratio will remain below our target threshold of 6.00-to-1.

We recorded a provisionbenefit for loan losses of less than $1 million for both the current quarter.three and six months ended November 30, 2019. In comparison, we recorded a benefit for loan losses of less than $1$2 million for both the same prior-year quarter.three and six months ended November 30, 2018. The credit quality and performance statistics of our loan portfolio remain strong. We had no payment defaults or charge-offs during the quarter, and no delinquent loans or nonperforming loans in our loan portfolio as of August 31,November 30, 2019 or May 31, 2019.

We provide additional information on our allowance for loan losses under “Credit Risk—Allowance for Loan Losses” and “Note 5—Allowance for Loan Losses” of this Report. For a description of our methodology for determining the allowance for loan losses, see “MD&A—Critical Accounting Policies and Estimates—Allowance for Loan Losses” and “Note 1—Summary of Significant Accounting Policies—Allowance for Loan Losses” in our 2019 Form 10-K.

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

 

Table 4 presents the components of non-interest income for the three and six months ended August 31,November 30, 2019 and 2018.

The significant variance in non-interest income between periods was primarily attributable to changes in the net derivative gains (losses) recognized in our condensed consolidated statements of operations. In addition, fee and other income increased by $7 million due to higher prepayment fees during the current quarter.six months ended November 30, 2019.

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 on occasion use treasury locks to manage the interest rate risk associated with 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 the substantial majority ofall our derivatives, for hedge accounting. Accordingly, changes in the fair value of interest rate swaps are reported in our condensed consolidated statements of operations under derivative gains (losses). However, we typically designate treasury locks as cash flow hedges. We did not have any derivatives designated as accounting hedges as of August 31,November 30, 2019 or May 31, 2019.

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 substantial majority of the floating rate payments under our swap agreements is 3-month London Interbank Offered Rate (“LIBOR”). 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, as interest 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 occur as interest rates decline or 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.

Table 5 presents the components of net derivative gains (losses) recorded in our results of operations. Derivative cash settlements expense represents the net periodic contractual interest amount for our interest-rate swaps for the reporting

The net derivative gains of $183 million for the three months ended November 30, 2019 were attributable to a net increase in the fair value of our pay-fixed swaps resulting from an increase in medium- and long-term interest rates during the current quarter. The net derivative losses of $396$212 million infor the current quartersix months ended November 30, 2019, were attributable to a net decrease in the fair value of our pay-fixed swaps resulting from a decline in interest rates across the swap curve, with medium- and longer-termshort-term interest rates experiencing a steepergreater decline than short-termmedium- and long-term rates. The swap curve remained inverted, as short-term interest rates continued to exceed medium- and longer-termlong-term interest rates as of the end of the current quarter, as depicted by the November 30, 2019, August 31, 2019 and May 31, 2019 swap curves presented in the comparative swap curves chart below.

The net derivative gains of $7$63 million and $71 million in the same prior-year quarterthree and six months ended November 30, 2018, respectively, were attributable to a netan increase in the fair value of our pay-fixed swaps resulting from a slightan increase in medium-and long-term interest rates across the swap yield curve, as depicted by the

Our derivative portfolio consists of a higher proportion of pay-fixed swaps than receive-fixed swaps, with pay-fixed swaps representing approximately 70% and 68% of the outstanding notional amount of our derivative portfolio as of both August 31,November 30, 2019 and May 31, 2019.2019, respectively. The profile of our interest rate swap portfolio, however, may change as a result of changes in market conditions and actions taken to manage exposure to interest rate risk. The average remaining maturity of our pay-fixed and receive-fixed swaps was 18 years and four years, respectively, as of August 31,November 30, 2019. In comparison, the average remaining maturity of our pay-fixed and receive-fixed swaps was 19 years and four years, respectively, as of August 31,November 30, 2018.