Annual Report
November 30, 2022

Flaherty & Crumrine Preferred and Income Fund

To the Shareholders of Flaherty & Crumrine Preferred and Income Fund (“PFD”):

Fiscal 2022 came to an end on November 30, 2022, closing out a challenging year for preferred and income securities. Total return¹ on net asset value (“NAV”) was -3.2% for the fourth fiscal quarter² and -15.6% for the full fiscal year. Total return on market price of Fund shares over the same periods was -8.5% and -29.4%, respectively.

 

TOTAL RETURN ON NET ASSET VALUE
For Periods Ended November 30, 2022
(Unaudited)

  

(1)Since inception on January 31, 1991.

(2)The Bloomberg US Aggregate Bond Index is a broad-based index that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

(3)The S&P 500 is a capitalization-weighted index of 500 common stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. In addition, NAV performance will vary from market price performance, and you may have a taxable gain or loss when you sell your shares.

 

Markets in 2022 were defined by uncertainty, with a constant push and pull between rate hikes by the Federal Reserve and investor expectations about when the tide would turn and once again usher in lower interest rates (i.e., the Fed’s “pivot”). On one hand, the pace of Fed rate increases was the fastest since 1980-81, including four consecutive 0.75% hikes and a cumulative total of 4.25% since the first tightening in March 2022. The pace of hikes felt new for everyone, but many investors have never known higher interest rates or inflation much over 2% and have been conditioned by years of easy policy to “buy the dip” when markets weaken. Uncertainty is a market’s kryptonite, and markets faced plenty of it. The result this year was a high-correlation selloff in nearly all risk assets (equities, fixed income, loans, real estate) and more than one false-start recovery rally during the year.

In 2021, investors accepted that inflation would be “transitory” and lower interest rates were here to stay. In 2022, surprisingly high and persistent actual inflation caused a flat-footed Fed (and investment community) to play catch-up and repeatedly shift their rate expectations upward. Markets are forward looking, although often myopic, and much of the pain in 2022 resulted from market expectations leading up to surprise inflation. The 10-year Treasury ended 2021 at 1.50% and spent most of the prior two years well below this level (yield of 0.50% in August 2020). With little fear that higher interest rates would be necessary to push down inflation, credit spreads narrowed. Similarly, common stock prices rose in part on a rebound in earnings as the pandemic receded but also because discount rates were so low. Markets were priced for near perfection, and surprise inflation upended assumptions supporting risk assets.

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¹Following the methodology required by the Securities and Exchange Commission, total return assumes dividend reinvestment.

²September 1, 2022 – November 30, 2022

Portfolio performance in 2022 was driven by higher interest rates and wider credit spreads, along with broad-market macro factors that accompany most market selloffs, including fund outflows (de-risking), thinner trading markets, and investor de-leveraging. The Fund’s focus on intermediate duration and call protection—owning fixed-reset or fixed-to-float structures with healthy backend reset spreads and avoiding most low-coupon fixed-rate securities—resulted in less overall impact from higher rates than some other segments of preferred and credit markets. For comparison, the Bloomberg US Long Credit³ total return over the same fiscal period ending November 30, 2022, was -24.7%.

Credit quality remains a highlight of the preferred and contingent capital securities (CoCo) market, and investors are now earning much higher yields on these credits. Banks remain very well capitalized, highly regulated, and most are asset-sensitive—which means earnings should increase with higher interest rates. Insurance companies have been longing for higher interest rates to boost portfolio yields, and they finally have arrived. Higher interest rates should also reduce pressure on insurance liability calculations. Energy issuers, pipelines in the case of the Fund’s portfolio, have been buoyed by higher commodity prices and potential increases in usage because of a shifting energy landscape. This stands in contrast to securities of high-yield (junk) issuers, where higher interest rates are likely to be more concerning due to their weaker balance sheets and greater exposure to rising interest costs and slower economic growth.

While higher interest rates have impacted asset values, they have also squeezed the Fund’s distributable income. The Fund uses leverage to enhance distributable income, earning the positive spread between asset yields and leverage cost. A slow increase in short-term rates would have allowed for a measured transition, but the pace and size of rate hikes have caused leverage costs to increase materially and quickly. Leverage continues to provide more distributable income compared to no leverage, but the spread has narrowed, and incremental income from leverage declined. The Fund’s goal is to pay out dividends consistent with portfolio earnings, and not maintain an artificially high dividend that is actually a return of shareholders’ capital. Accordingly, we have adjusted the Fund’s dividend lower over the course of the year to reflect its lower distributable income.

Preferred and CoCo issuers, along with U.S. consumers broadly, appear to be in a strong position to weather this storm—but time is the only remedy for macro issues outside the Fed’s purview, such as supply chain bottlenecks or the war in Ukraine. Holding or adding to investments when markets are lower and sentiment weak can be uncomfortable for investors, but we believe there is opportunity in preferred and CoCo markets for long-term investors seeking income and solid credit quality.

Please read the discussion topics that follow for a broader discussion of our economic and credit outlook, and other matters of interest to shareholders.

Finally, we ask that shareholders elect their delivery preferences for shareholder reports. Electronic delivery is recommended and helps lower Fund expenses, but printed reports remain available.

Sincerely,

The Flaherty & Crumrine Portfolio Management Team

December 31, 2022

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³The Bloomberg US Long Credit Index measures the performance of investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related debt with at least ten years to maturity. It is composed of a corporate and a non-corporate component that includes non-US agencies, sovereigns, supranationals and local authorities.

DISCUSSION TOPICS

(Unaudited)

Fund Performance

The table below presents a breakdown of the components that comprise the Fund’s total return on NAV over both the recent six months and the Fund’s fiscal year. These components include: (a) total return on the Fund’s portfolio of securities; (b) the impact of utilizing leverage to enhance returns to shareholders and accretive impact of the Fund’s at-the-market program (“ATM Program”); and (c) Fund operating expenses. When these components are added together, they comprise total return on NAV.

Components of PFD’s Total Return on NAV
for Periods Ended November 30, 2022

For the six-month and one-year periods ended November 30, 2022, the ICE BofA 8% Constrained Core West Preferred & Jr Subordinated Securities Index (P8JC)^1,2 returned -3.2% and -11.6%, respectively. This index reflects various segments of the preferred securities market constituting the Fund’s primary focus. Since this index return excludes all expenses and the impact of leverage, it compares most directly to the top line in the Fund’s performance table above (Total Return on Unleveraged Securities Portfolio).

While our focus is primarily on managing the Fund’s investment portfolio, a shareholder’s actual return is comprised of the Fund’s monthly dividend payments plus changes in the market price of Fund shares. The table and chart below depict total return on net asset value and total return on market price over the preceding 10 fiscal years.

Current performance may be lower or higher than the quoted past performance, which cannot guarantee future results. In addition, NAV performance will vary from market price performance, and you may have a taxable gain or loss when you sell your shares and taxable income when you receive distributions.

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¹The Fund’s Benchmark Index is the ICE BofA 8% Constrained Core West Preferred & Jr Subordinated Securities Index (P8JC), which includes U.S. dollar-denominated investment-grade or below investment-grade, fixed rate, floating rate or fixed-to-floating rate, retail or institutionally structured preferred securities of U.S. and foreign issuers with issuer concentration capped at 8%. For periods prior to 4/1/12, the benchmark was 50% of the monthly return on the ICE BofA Hybrid Preferred Securities 8% Constrained Index (P8HO) and 50% of the monthly return on the ICE BofA US Capital Securities US Issuers 8% Constrained Index (C8CT). P8HO includes taxable, fixed-rate, U.S. dollar denominated investment-grade, preferred securities listed on a U.S. exchange. C8CT includes investment grade fixed rate or fixed-to-floating rate $1,000 par securities that receive some degree of equity credit from the rating agencies or their regulators. All index returns include interest and dividend income, and, unlike the Fund’s returns, are unmanaged and do not reflect any expenses.

²The benchmarks from ICE Data Indices, LLC (“ICE Data”) are used with permission. ICE Data, its affiliates and their respective third-party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ICE Data, its affiliates nor their respective third-party providers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICE Data, its affiliates and their respective third-party suppliers do not sponsor, endorse, or recommend Flaherty & Crumrine Incorporated, or any of its products or services.

In a more perfect world, the market price of Fund shares and its NAV would track more closely. If so, any premium or discount (calculated as the difference between these two inputs and expressed as a percentage) would remain relatively close to zero. However, as can be seen in the chart below, this often has not been the case.

Although divergence between NAV and market price of a closed-end fund is generally driven by supply/demand imbalances affecting its market price, we can only speculate about why the relationship between the Fund’s market price and NAV hasn’t been closer.

U.S. Economic & Credit Outlook

The U.S. economy rebounded in the second half of 2022 after contracting slightly in the first half. Although data for the fourth quarter is not yet available, we expect real GDP to expand by about 0.5% in 2022 (Q4/Q4), far below 2021’s 5.7% gain. Strong business investment and moderate gains in consumer spending offset a plunge in residential investment. Inflation intensified, reaching levels not seen since the early 1980s, and prompted the Federal Reserve to hike the federal funds rate by 4.25% from March through December. In turn, yields on Treasury securities rose sharply across maturities. Credit quality remained good, but recession fears pushed credit spreads wider. Higher interest rates and wider credit spreads combined to produce negative returns on corporate and high yield bonds and preferred and contingent capital securities in 2022.

Nonfarm payroll employment expanded by an average of 408,000 jobs per month over 12 months ending in November 2022—a very strong pace of job growth. Labor demand pushed up average hourly wages by 5.1% YoY in November, producing a 6.2% jump in wage and salary income, though a slowdown in other income categories and high inflation left real disposable personal income down 2.5%.

Personal consumer expenditure (PCE) rose 2.0% after inflation, as consumers tapped savings to support spending that outpaced income. With the savings rate at just 2.4%, we see little room for further cuts to savings and expect PCE growth to moderate in 2023, although continued strength in wage and salary income and lower inflation may keep real spending near its current pace in the first half.

Real business investment was a highlight, up 4.7% at an annual rate through the first three quarters of 2022. With workers hard to find and wages up, businesses increased investment to improve productivity. We expect growth in business investment to moderate in 2023 but remain positive.

In contrast, real residential investment plunged 16.6% annualized over the first three quarters of 2022 as two years of rapid home price gains starting in mid-2020 collided with higher mortgage rates in 2022, sharply reducing home affordability. Combined new and existing home sales in November were down by almost a third from December 2021. After peaking in June, home prices have declined and probably have further to go. However, although activity is down sharply, we do not expect a housing bust. Most borrowers bought their homes at significantly lower prices, locked in much lower mortgage rates, and were better qualified to service their debt than during the 2008-2009 financial crisis. Residential investment is likely to remain weak in 2023, but with home sales already down sharply, we expect the pace of decline to moderate over the year.

Other sectors of the economy were mixed. Real government spending was little changed through the first three quarters of 2022 as pandemic-related programs wound down. Net exports had almost no impact on GDP growth in the first half of 2022 but contributed most of Q3’s 3.2% gain. Finally, inventories were a consistent but modest drag on growth in 2022. Looking ahead, we expect moderate real growth in government spending in 2023, little contribution from inventories, and moderate drag from trade.

Inflation soared in 2022 to the highest levels since the early 1980s, accommodated by earlier expansive monetary and fiscal policy. Supply chain bottlenecks from the pandemic and a boom in demand from consumers pushed up goods prices in 2021 and early 2022. Services prices followed as consumers shifted spending back toward services in late 2021 and 2022, while the war in Ukraine boosted food and energy prices.

In response to both easing supply chain pressures and tighter monetary policy, inflation should decline significantly in 2023. Already, goods prices have slowed sharply, but services inflation has been stickier. While we are confident that goods inflation will slow quickly, labor supply remains tight, and it may take a recession to bring down services inflation more meaningfully, which we do not expect until the second half of 2023.

The Federal Reserve belatedly but aggressively reacted to inflation with the largest series of rate increases in four decades, raising the federal funds rate by some 425 bp. Moreover, Federal Open Market Committee (FOMC) members

project a year-end 2023 fed funds rate of 5.1%, which implies another 75 bp or so of rate hikes ahead—and no easing until 2024. In response, ten-year Treasury yields rose by 236 bp to 3.88% and 30-year Treasuries rose by 206 bp to 3.97% from year-end 2021 to 2022.

Credit spreads widened as high inflation and rapid-fire rate hikes raised both benchmark interest rates and fears of credit defaults. However, credit quality, in contrast to credit spreads, remains favorable. Macroeconomic indicators such as business and consumer debt-to-GDP have continued to trend down; debt service ratios are up a bit but remain low; and business bankruptcy filings are near historic lows. Banks’ net interest margins have already increased meaningfully, and loan delinquencies and charge-offs are low and have shown no material deterioration in 2022. Insurance companies will benefit from higher yields on their investment portfolios. Admittedly, banks and insurers absorbed mark-to-market losses on their securities portfolios as yields rose, but we think financial companies have the capital, earnings, and reserves to manage strains that a recession might bring.

Looking ahead, we expect tighter monetary policy to push the U.S. economy into a mild recession in the second half of 2023, which should accelerate inflation’s decline toward the Fed’s 2% target. Core PCE inflation should fall below 3% in early 2024 and allow the Fed to begin easing monetary policy. Forward interest rates are more optimistic and suggest the Fed will start easing in the second half of 2023. We expect the fed funds rate to remain at a “terminal” rate of about 5% through year-end 2023 before falling in 2024. As a result, we think 10- and 30-year Treasury rates could move modestly higher as markets adjust to a later “pivot” by the FOMC. As interest rates fall and an economic recovery begins in 2024, credit fears should recede. Markets probably would start to anticipate that sometime in 2023. With inflation currently elevated, the Fed tightening monetary policy, the global economy slowing, and the war between Ukraine and Russia still raging, it may be too soon to expect a near-term rebound in credit markets. However, yields are up significantly from a year ago, and we think most of the adjustments to higher rates and wider credit spreads are behind us. We believe long-term investors can earn attractive yields on preferred and contingent capital securities today as they wait for better days ahead.

Federal Tax Advantages of 2022 Calendar Year Distributions

In calendar year 2022, approximately 90.2% of distributions made by the Fund were eligible for treatment as qualified dividend income, or QDI. Depending on an individual’s level of income, QDI can be taxed at a rate of 0%, 15% or 20%.

For an individual in the 32% marginal tax bracket, this means that the Fund’s total distributions will only be taxed at a blended 16.7% rate versus the 32% rate which would apply to distributions by a fund investing in traditional corporate bonds. This tax advantage means that, all other things being equal, for every $100 distribution that such individual receives from the Fund for the calendar year, the same individual would have had to receive approximately $123 in distributions from a fully-taxable bond fund to net the same after-tax amount as the distributions paid by the Fund.

For detailed information about tax treatment of particular distributions received from the Fund, please see the Form 1099 you receive from either the Fund or your broker.

Corporate shareholders also receive a federal tax benefit from the 40.4% of distributions that were eligible for the inter-corporate dividends received deduction, or DRD.

It is important to remember that composition of the portfolio and income distributions can change from one year to the next, and that the QDI or DRD portions of 2023’s distributions may not be the same (or even similar) to 2022.

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OVERVIEW

November 30, 2022 (Unaudited)

 

Additional portfolio information of interest to shareholders is available on the Fund’s website at http://www.preferredincome.com

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS

November 30, 2022 

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022 

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022 

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022 

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022

 

 

Flaherty & Crumrine Preferred and Income Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

November 30, 2022