SEC Form N-CSRS filed by Flaherty & Crumrine Preferred and Income Opportunity Fund Inco

Semi-Annual Report
May 31, 2023

Flaherty & Crumrine Preferred and Income Opportunity Fund

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

The first half of the fiscal year was a tale of two quarters, with markets rebounding sharply in fiscal-Q1 after a weak performance in 2022, then taking another step backwards in fiscal-Q2 in response to regional bank concerns. Total return¹ on net asset value (“NAV”) was -10.0% for the second fiscal quarter² and -4.5% for the first half of the fiscal year. Total return on market price of Fund shares over the same periods was -15.0% and -15.3%, respectively.

TOTAL RETURN ON NET ASSET VALUE
For Periods Ended May 31, 2023

(1)Since inception on February 13, 1992.

(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.

Fiscal-Q1 NAV returns experienced a nice rebound from the weakness of 2022, with the strongest performance concentrated in January. A turn of the calendar meant the end of tax-loss selling, which turned out to be a meaningful drag on market performance in late 2022 – probably more than investors realized at the time. Modestly favorable economic news in January, including some improvement on inflation, helped push Treasury yields lower and further supported a sentiment change. Markets experienced a few false-starts in 2022, anticipating the Federal Reserve was nearing an end to its tightening cycle, and January was the latest bout of optimism.

While a market recovery was a welcome change from 2022, much uncertainty remained, and investors continued to focus on the outlooks for inflation, economic growth, and Fed policy. Lower Treasury yields were mostly concentrated in the mid- to long-term parts of the curve, resulting in near-record levels of Treasury yield-curve inversion—an indication that markets believed the Fed was likely to overshoot with rate hikes and push the economy into a recession. Economic data over the subsequent months was modestly encouraging, but it also demonstrated inflation was sticky and improvement toward the Fed’s goal could be slow. The Fed raised its benchmark rate 25 bps at each Federal Open Market Committee (FOMC) meeting in February, March, and May—finally pausing at the June meeting but indicating additional hikes are likely to be necessary.

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

²March 1, 2023 – May 31, 2023

New issue markets came alive once again in early 2023, and overall, the offerings looked attractive. There was a mix of U.S. preferred and foreign contingent capital (CoCo) issuance, most with front-end coupons that reflected the substantial increase in interest rates over the prior year. U.S. banks issued in a range of 6.25%-7.375% front-end coupon, while CoCo securities came in a range of 7.50%-8.25%. Much of this issuance qualified for QDI tax rates, which boosted taxable-equivalent yields to 8.0-10.5%. Back-end spreads mostly remained in the 300-400 bps range, although a few of the U.S. banks were just inside 300 bps—spreads we thought were attractive based on credit metrics of most issuers.

The regional bank panic began after Silvergate Capital (SI), a cryptocurrency-focused bank, entered voluntary liquidation in early March. Soon thereafter, two banks—Silicon Valley Bank (SIVB) and Signature Bank NY (SBNY)—entered receivership after investors and depositors became worried about unrealized losses in investment portfolios and deposits at those banks made a quick exit. Credit Suisse (CS), a Swiss bank, also failed in mid-March due to deposit flight, causing concerns to spread globally. While well-capitalized by regulatory standards, these banks were unable to meet liquidity demands related to deposit outflows—a classic run-on-the-bank—and regulators closed (or in CS’s case, merged into UBS) these institutions.

Actions by the Federal Reserve, Federal Home Loan Banks, and Treasury to provide liquidity to US banks (backed by securities and loans) helped stabilize bank balance sheets and sentiment, although it was clear that investor appetite for regional banks had been severely reduced. This bout of market turmoil resulted in significant weakness in regional and community banks, as investors worried about deposit flight expanding more broadly. Another bank, First Republic Bank (FRC), was similarly injured in March, but remained in a state of limbo for weeks as potential suitors evaluated a possible investment. FRC ultimately entered receivership in early May, with most assets being sold to JPMorgan Chase in the process. The Fund’s exposure to these names, as a percentage of total managed assets, as of February 28, 2023, was SI: 0%, SIVB: 0.3%, SBNY: 0.4%, CS: 1.0%, and FRC: 0.1%.

Deposit flight was the proximate cause of failure at each of these banks. For the U.S. banks, deposits were concentrated by client type and, in most cases, comprised of large uninsured balances (balances above standard FDIC insurance limits). For U.S. banks, unrealized losses in investment and loan portfolios, brought on by sharply higher interest rates, was the primary concern. Most investors expected unrealized losses to be borne by common stock investors in the form of lower earnings, but the deposits funding those investments simply were not stable enough to support this workout over time. Similarly, cs expected business losses from an ongoing restructuring would continue to be borne by common stock investors over time, but funding (deposits) left the bank with fantastic speed – likely exacerbated by U.S. regional bank problems unfolding around the same time. In all cases, confidence eroded, and deposits withdrew at a rapid pace.

While even a single bank failure is undesirable, we believe the global banking system, consisting of over 5,000 banks, is strong – including most U.S. regional and community banks. Asset-liability mismatches that initially went undetected eventually were exposed when interest rates rose rapidly in 2022 – but the extent of this mismanagement is bank-specific and, in our view, does not threaten the banking system. Accounting and regulatory rules contributed to a delay in its recognition, and there is no question a review of these practices is warranted. However, many sound banks were assumed guilty by association, and preferred prices declined broadly. Calendar-Q1 bank earnings reported in April demonstrated continued strength in earnings, low loan charge-offs, and substantially more deposit stability than feared back in March.

The path forward for regional banks is well paved but has been lengthened, and we believe confidence will not return quickly. Funding costs have risen, which will pressure net margins and, therefore, earnings. Banks are shoring up liquidity to protect against deposit flight, which will result in higher costs and tighter lending standards. Unrealized losses in investment and loan portfolios likely will require some years to fully resolve but should be borne by common stock investors through lower earnings. Importantly, bank investment portfolios, in general, are very high quality (mostly government-backed securities), and unrealized losses were generated by temporary interest rate exposure, not by potentially permanent credit impairment. Assuming bank funding remains available, we expect that actual losses on these portfolios should be near zero as securities are paid down or mature.

Fixed-income markets, including preferreds and CoCos, have struggled over the last 18 months due to a historically rapid rise in interest rates and, more recently, bank-specific stresses. While the Fed has indicated modest additional tightening may be required and these elevated short-term rates may last longer than expected, markets reflect most of these new realities and, we believe, offer good upside potential moving forward. A peak in short-term rates later this year, and subsequent moves lower in coming years would help widen the Fund’s income margin over time and improve distributable income. We believe banks will prove more resilient than current sentiment seems to imply, and current depressed valuations should improve over time. None of this will happen overnight, but in our view the long-term outlook for preferreds and CoCos is attractive at current levels.

Sincerely,

The Flaherty & Crumrine Portfolio Management Team

June 30, 2023

DISCUSSION TOPICS

(Unaudited)

Fund Performance

The table below presents a breakdown of the components that comprise the Fund’s total return on NAV over the recent six months. 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 PFO’s Total Return on NAV
for the Six Months Ended May 31, 2023¹

For the six-months ended May 31, 2023 the ICE BofA 8% Constrained Core West Preferred & Jr Subordinated Securities Index^SM (P8JC)^1,2 (Benchmark Index) returned 0.3%. 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.

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%. 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

Gross domestic product after inflation (real GDP) rose by 2.0% in the first quarter of 2023, compared to an average of 2.9% in the second half of 2022. However, stronger consumer spending and a smaller decline in residential investment were only partially offset by a slowdown in business investment, leaving domestic final sales up 3.5% in Q1 compared to an average of 1.1% in 2H2022. Economists expect 1.2% real GDP growth in the second quarter, followed by flat to slightly negative growth in the second half of this year.¹

Nonfarm payroll employment expanded by an average of 302,000 jobs per month since the Fund’s fiscal year-end, which is remarkably strong given the current expansion’s age (over three years now) and rate hikes totaling 5% since March 2022. Average hourly earnings growth slowed, but the broader employment cost index accelerated to 4.5% over the 12 months ending in March (latest data available), which is too high to be consistent with the Fed's 2% inflation target given muted labor productivity.

Strong employment and rising wages drove solid gains in wage and salary income, and overall personal income rose 4.7% over the six months ending in May. Over the same period, personal consumption expenditure (PCE) was up 6.1% in current dollars and 2.6% after inflation, led by services spending. Consumer confidence rose, with the average of major confidence surveys in June reaching the highest level since January 2022. In short, consumer spending remained resilient despite much tighter monetary policy. However, we expect dwindling savings, higher interest rates, and renewed payments on federal student loans to dampen consumer spending and employment in the second half of 2023.

Real business investment rose just 0.6% in the first quarter of 2023 as an 8.9% decline in equipment spending blunted a 15.8% surge in structures. Manufacturing companies are investing in facilities to bring some production back onshore and, where available, take advantage of incentives authorized in the Inflation Reduction Act (IRA) and CHIPS and Science Act of 2022 (CHIPS)—spending that probably has further to run. Spending on capital equipment, on the other hand, is likely to continue to shrink, given lower capacity utilization, slowing manufacturing orders, and much higher borrowing costs. We expect at best tepid business investment growth overall, and several negative quarters are possible. Along with residential investment, this is a sector that is feeling meaningful impact from tighter monetary policy.

Residential investment fell by 4.0% in the first quarter, substantially better than in 2022, and home sales are up since fiscal year-end. A high level of employment sustained good underlying demand for homes, but sharply higher mortgage rates pressured home prices. We believe residential investment is likely to remain soft in the second half of 2023, but with home sales already down sharply, further declines should be modest.

Other sectors of the economy were mixed. Real government spending rose strongly as the IRA and CHIPS acts helped drive federal nondefense spending up 10.5% in Q1. Total real federal and state and local government spending was up 5.0%. However, federal spending limits agreed to in the recent debt ceiling deal should slow the growth of federal spending in 2024. Net exports added 0.6% to Q1 real GDP, but a sizable slowdown in inventory accumulation subtracted 2.1%. We expect moderate real growth in government spending, a rebound in inventories, but a return to drag from trade in the second half 2023.

Inflation slowed in spots but remains elevated. Lower energy prices helped push overall PCE inflation down to 3.4% since the Fund's fiscal year-end compared to 4.3% over the prior six-month period, but the PCE deflator excluding volatile food and energy prices held steady at 4.6%. Similarly, overall consumer price index (CPI) inflation slowed to 3.2% from 5.1% over the same periods, while CPI excluding food and energy prices slowed only modestly to 5.1% from 5.6%—likely still too high to convince the Fed that monetary policy is restrictive enough to quell inflation. Money supply continued to shrink as the Fed drained excess liquidity added during the pandemic and bank lending slowed.

We continue to expect goods inflation to fall on a combination of improving supply chains, flat to lower energy prices, and slowing global economic growth. Services inflation should follow, albeit more slowly, with larger declines coming when and if the economy slips into recession. The U.S. economy may avoid recession, but if it does, we think the Fed will raise rates further or hold them at the peak rate longer than the market currently expects.

¹ Bloomberg Monthly Economic Survey, June 23, 2023, Bloomberg L.P.

The Federal Reserve continued to lift its federal funds rate target (5.00-5.25% as of June 30, 2023) but first slowed the pace of hikes in early-2023 and then paused, or more likely “skipped,” a rate hike at its June 14 meeting. FOMC members project a year-end 2023 fed funds rate of 5.6%, which implies another 50 bp of rate hikes ahead. Market forward rates imply the FOMC will cut the fed funds rate beginning in early 2024 by a total of 125 bp that year. Although we anticipate the U.S. economy will slip into a mild recession in 4Q2023, we think it will take time for slower growth to translate into lower core inflation. We agree with market expectations that the fed funds rate should peak soon but think that rate cuts will begin about six months later, which suggests modestly higher Treasury rates ahead.

Credit quality generally remains favorable for now—better than before the pandemic by most metrics—and overall private-sector leverage is low. However, debt service ratios have increased due to higher interest rates, bankruptcy filings are up, loan delinquency and charge-off rates at banks are off their lows, and bank lending standards have tightened significantly. Borrowers will find it more difficult and expensive to obtain new financing or refinance existing debt, which could raise defaults. Most banks have already raised loan-loss reserves given a more challenging economic outlook, and we think they are well prepared to manage strains that a recession may bring. Nonetheless, recession worries could spark renewed banking problems, especially if the Fed raises rates more aggressively than the market anticipates.

Looking ahead, we expect core inflation to fall enough by mid-2024 to prompt Fed easing. As inflation recedes and interest rates fall, an economic recovery should begin in 2024, and credit fears should diminish. At current yields, we see considerable opportunity for long-term investors in preferred and contingent capital securities.

A Review of 2023 Dodd-Frank Bank Stress Tests

On June 28, the Federal Reserve released its 2023 large-bank Dodd-Frank Act stress test results. They were mostly as expected, and all 23 banks “passed” the 2023 stress test amid the prevailing global economic uncertainty. The 2023 “severely adverse scenario” modeled banks’ financial performance assuming unemployment peaking at 10% in 3Q2024, real GDP down 8.75%, equities down 45%, house prices down 38%, and commercial real estate down 40% from their levels at the end of 2022, among other factors. Under this scenario, the average minimum common equity Tier 1 (CET1) capital ratio for this year’s 23 bank participants was 10.1% versus 9.7% in the June 2022 test (34 banks took the test last year). The results of this year’s stress test demonstrate that large U.S. banks remain “well-capitalized,” and no bank breached minimum capital requirements during the two-year stress period.¹ Under all scenarios, the 23 large banks maintained capital buffers that were significantly above the Fed’s required minimum, after capital actions. Large U.S. banks appear well prepared for a recession, should one arrive, over the next several years.

The Fed also conducted its 2023 Comprehensive Capital Analysis and Review (CCAR) to evaluate bank capital plans considering the stress tests results. Our main CCAR takeaway is that banks should continue to exercise discipline regarding common shareholder returns given Basel III “Endgame” proposals that are expected to increase large-bank capital requirements and are due to be announced in 3Q2023. In addition, declining net interest margin due to rising bank deposit costs and persistent global economic uncertainty argue for a cautious approach to shareholder returns. Since the test results were published, most of the U.S. banks announced moderately higher common stock dividends, while some left them unchanged. There were no big share repurchase announcements among the U.S. banks, with most leaving current buyback programs in place and some placing them on hold. Stress Capital Buffers (SCB) declined significantly at many of these banks given good stress test results. Given ongoing monetary policy tightening and potential for slower economic growth—and possibly recession—ahead, we expect all banks to maintain robust capital levels and loan-loss reserves over coming quarters, which should help support preferred investors.

¹For stress test purposes, the benchmark for a “well-capitalized” bank remains CET1 of 4.5% of risk-weighted assets plus a specific Global Systemically Important Bank Holding Company (GSIB) surcharge, where applicable. To pass the stress test, a bank’s projected CET1 ratio must remain above that benchmark by a certain amount, called the Stress Capital Buffer (SCB). The Fed sets the SCB requirement for each of the banks annually. For quarterly reporting purposes, minimum CET1 for a “well-capitalized” bank remains the sum of the 4.5%, a GSIB surcharge, if any, and the specific SCB assigned to each bank.

Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OVERVIEW

May 31, 2023 (Unaudited)

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

Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS

May 31, 2023 (Unaudited)

Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

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Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

PORTFOLIO OF INVESTMENTS (Continued)

May 31, 2023 (Unaudited)

§Date shown is maturity date unless referencing the end of the fixed-rate period of a fixed-to-floating rate security.

*Securities eligible for the Dividends Received Deduction and distributing Qualified Dividend Income.

**Securities distributing Qualified Dividend Income only.

***Aggregate cost of securities held.

****Securities exempt from registration under Rule 144A of the Securities Act of 1933. These securities may be resold in transactions exempt from registration to qualified institutional buyers. At May 31, 2023, these securities amounted to $44,454,852 or 22.9% of total managed assets.

⁽¹⁾Perpetual security with no stated maturity date.

⁽²⁾All or a portion of this security is pledged as collateral for the Fund’s loan. The total value of such securities was $173,614,876 at May 31, 2023.

⁽³⁾All or a portion of this security has been rehypothecated. The total value of such securities was $77,492,259 at May 31, 2023.

⁽⁴⁾Represents the rate in effect as of the reporting date.

⁽⁵⁾Foreign Issuer.

†A Contingent Capital Security is a hybrid security with contractual loss-absorption characteristics.

‡The percentage shown for each investment category is the total value of that category as a percentage of total managed assets.

ABBREVIATIONS:

3ML— 3-Month ICE LIBOR USD A/360

ISDA5— 5-year USD ICE Swap Semiannual 30/360

SOFRRATE— Secured Overnight Funding Rate, Federal Reserve Bank of New York

SW5— 5-year USD Swap Semiannual 30/360

SW10— 10-year USD Swap Semiannual 30/360

T5Y— Federal Reserve H.15 5-Yr Constant Maturity Treasury Semiannual yield

T7Y— Federal Reserve H.15 7-Yr Constant Maturity Treasury Semiannual yield

T10Y— Federal Reserve H.15 10-Yr Constant Maturity Treasury Semiannual yield

Flaherty & Crumrine Preferred and Income Opportunity Fund Incorporated

STATEMENT OF ASSETS AND LIABILITIES

May 31, 2023 (Unaudited)