DFP Flaherty and Crumrine Dynamic Pfd and Income Fund Inc

FLAHERTY & CRUMRINE dynamic PREFERRED and INCOME FUND

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

The first half of Fiscal 2020 has been a tale of two very different quarters. A lot has changed in our world since the arrival of COVID-19, and markets have struggled to find their way amid much uncertainty. Total return¹ on net asset value (“NAV”) was -7.2% for the fiscal quarter² and -6.5% for the first half of the fiscal year. Total return on market price of Fund shares over the same periods was 4.2% and -1.3%, respectively.

The first fiscal quarter of 2020 was largely a continuation of 2019’s familiar themes. Financial conditions eased materially in 2019; credit quality remained healthy, especially for “financial” issuers; preferreds and contingent capital securities (“CoCos”) continued to offer a yield advantage compared to senior debt, presenting an attractive option for income investors in a low-yield environment. Many of the pressing issues from 2019 were also showing improvement, such as Brexit and US-China trade negotiations – leaving many investors looking to the November election as the next catalyst for market disruption.

All of that was upended in the second fiscal quarter by a novel coronavirus. It is clear the world was blindsided by COVID-19 and thoroughly unprepared for a pandemic of this speed and magnitude. Government response in the U.S. has been a patchwork of federal, state and local orders. The response was uneven, with some states imposing strict social distancing rules in mid-March and others waiting weeks after the first states acted. Removal of those restrictions has been equally uneven, with some areas moving slowly and others rapidly to reopen businesses and public activities. Scientific knowledge of this novel coronavirus is advancing but not as quickly as we would all prefer.

In response to COVID-19, and a sudden halt in economic activity brought on by measures to flatten its spread, prices of stocks and fixed-income securities in the first three weeks of March moved lower rapidly and relentlessly. While wider credit spreads were to be expected, markets were thin and investors in need of liquidity were forced to accept lower and lower prices.

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

2 March 1, 2020 – May 31, 2020

As prices declined, leverage ratios at some funds rushed higher and resulted in even more selling as leveraged investors raised cash to pay down borrowings. All told, over the course of a few weeks in March, it appears closed-end preferred funds alone repaid over $1 billion in leverage; open-end preferred funds saw outflows of almost $2 billion; and preferred ETFs saw outflows of more than $1.5 billion. Moreover, it appears similar trades were occurring in most segments of fixed-income markets (loans, municipals, high yield, investment-grade corporate credit). Overall, we estimate at least $5 billion left the preferred market in March. In light of the preferred market’s modest size, this was a significant amount of activity.

Selling of such magnitude over a short period of time resulted in drastic price changes and dislocations in every market segment – exceeding moves attributable to fundamental credit concerns. However, the extent of outflows and the amount of deleveraging so early in the process helped markets make a dramatic recovery since the lows of March 23, in many cases cutting losses by more than half. This impact of COVID-19 is far from over, and much economic loss is yet to be quantified – but at least we feel that markets have returned to evaluating “credit” more than chasing “liquidity”.

In response to this crisis, the Federal Reserve reestablished monetary-policy tools from 2008-2009 – and in many cases enhanced and expanded programs to better match specifics of this event. The Fed has moved swiftly, been transparent with markets, and committed very large amounts to ensure our financial system continues to operate effectively. The government also enacted fiscal policies to help companies and consumers weather the storm. The combined dollar amounts are staggering and could have negative repercussions at a later time, but we believe they are necessary responses to this crisis.

COVID-19 and related social-distancing orders resulted in a material decline in global demand for oil as economic activity suddenly slowed in many countries. A second, and seemingly unnecessary, oil crisis developed as OPEC+ participants argued over much-needed production cuts – with Saudi Arabia actually increasing oil production and driving prices even lower. Even though they only comprise about 2% of the Funds’ benchmark, energy companies were by far the worst performing sector in the benchmark with a -41% total return over the first calendar quarter and a -9% total return over the first half of the fiscal year. As a result, even the portfolio’s moderate overweight exposure of 6.3% to energy companies as of May 31, 2020 was a significant drag on performance since the drop in the price of oil began. However, unlike exploration and production companies, the portfolio’s energy holdings are pipeline and midstream companies that have significantly less commodity price exposure and have the ability, we believe, to tolerate a period of slack demand and lower energy prices.

We have long held that U.S. banks were strong credits, and we continue to believe they will brave this crisis. Losses should be limited mostly to earnings events, and their strong levels of capital and loan-loss reserves should support preferreds. U.S. banks generally have suspended stock buybacks (and must continue to suspend them until at least September 30), and average dividend payout ratios are conservative in the 30-40% range. Notably, all U.S. banks passed their Federal Reserve stress-tests in late June (more details on these in the discussion topics that follow).

European banks as a group did not enjoy so strong a position entering this crisis, but we believe certain European banks remain very solid credits. Dividend payout ratios were much higher for European banks, and, as a precaution, their common stock dividends have been eliminated until further notice. While this did spook CoCo investors initially, subsequent communications from regulators indicated support for CoCo coupons to continue.

Amidst mostly unsettling headlines in 2020, we were pleased to announce an increase in the Fund’s dividend rate starting with the May, 2020 dividend. The Fund’s cost of leverage is benchmarked to one-month LIBOR – which was at 0.1825% as of May 29, 2020. This results in all-in leverage cost today of approximately 1.0%, down from an average of about 3.1% in fiscal year 2019. We currently expect LIBOR to remain low for the foreseeable future, which should continue to support the Fund’s dividend rate. In addition, although leverage is dynamic and may need to be adjusted in the future, the Fund did not reduce leverage during the fiscal period.

COVID-19 already has proven to be a terrible event in both human and economic terms, and it is still very much with us. Although markets have calmed considerably from their drastic initial moves, no one yet knows the full magnitude of this calamity. Mandated safer-at-home orders have slowly been supplemented with continued social-distancing and mask requirements, along with a cautious, staggered approach to re-opening our economy. There remains too much uncertainty to predict timing on any of this with any specificity.

In the meantime, we continue to monitor credits and security valuations closely and work to position our portfolios to meet their objectives – and for the best chance of recovery in asset values as the pandemic recedes. We remain cautiously optimistic on the preferred and CoCo markets, especially from the viewpoint of long-term income investors. Flow data indicates investors are returning to fixed-income, absorbing record levels of new issue debt over the last two months. However, we acknowledge that there is limited modern historical precedent for this pandemic and its global economic impact, making our “crystal ball” unusually cloudy.

We encourage you to read the discussion topics that follow, as we dig deeper into subjects of interest to shareholders. In addition, visit the Fund’s website, www.preferredincome.com, for timely and important information.

Sincerely,

The Flaherty & Crumrine Portfolio Management Team

July 2, 2020

¹The ICE BofA 8% Constrained Core West Preferred & Jr Subordinated Securities Index^SM (P8JC) 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%. 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, as shown in the above chart, 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.

Based on a closing price of $24.33 on June 30^th and assuming its current monthly distribution of $0.1505 does not change, the annualized yield on market price of Fund shares is 7.4%. Of course, there can be no guarantee that the Fund’s dividend will not change in the future.

U.S. Economic and Credit Outlook

The U.S. economy slowed sharply in the first quarter of 2020 as “Safer at Home” orders proliferated in the second half of March and many businesses – especially in travel and hospitality – suspended or curtailed operations. Economic activity promptly slumped, making February the last month of a 128-month expansion and March the start of a severe, but likely short, recession. Inflation-adjusted gross domestic product (real GDP, annualized) fell by 5.0% in Q1, led by a 6.8% drop in personal consumption. Economists expect the second quarter of 2020 to post by far the largest decline on record: ˗35%.

We expect the second quarter to mark the low for this contraction. With many businesses at least partially reopened, growth expectations for Q3 and Q4 are 19.8% and 8.8%, respectively. For the full year 2020, economists forecast a decline in GDP of 5.7%, rebounding to +4.0% in 2021. These forecasts compare to expectations for growth of about 2% in 2020 and 2021 prior to the COVID-19 pandemic. Beyond 2021, we expect the economy to expand a bit faster than the prior 2% trend for several years as businesses that closed are replaced by new ones and absorb workers whose jobs disappeared during the recession. It’s likely to take a number of years to recover economic growth lost to the pandemic, however.

Developments in the labor market over the past few months vividly illustrate the sudden and devastating economic impact of coronavirus and public and private responses to it. Job growth remained solid early in the first quarter. Nonfarm payroll jobs rose by an average of 233,000 jobs per month in January and February before falling by 1.4 million jobs in March and a staggering 20.8 million in April, pushing the unemployment rate to 14.7%. Many job losses were temporary, however, and May and June saw increases of 2.7 million and 4.8 million jobs, respectively, as businesses reopened and rehired workers. The unemployment rate dropped back to 11.1% in June, although that is still far above February’s 3.5% rate.

Renewed growth in employment and consumer spending has been substantially better than expected and reflects both the economy’s inherent resilience and fiscal and monetary policy responses to the crisis. Personal income and consumption slumped as “Safer at Home” orders were imposed but rebounded strongly in April (income) and May (consumption) as stimulus checks arrived, businesses began to reopen and consumer confidence rose. Savings jumped and should help sustain consumer spending as fiscal support tapers over coming quarters.

Home sales slumped as the pandemic unfolded, but they have started to pick up as restrictions have eased. We expect residential investment to turn upward again in the third quarter, although the strength of any housing rebound beyond that will depend on job recovery, which remains uncertain. Business investment, which slipped 6.4% in the first quarter and probably even more in Q2, is likely to remain subdued given sizable excess capacity currently. Stronger consumer spending and a revival of exports should pull it up eventually, but that may take a couple of quarters.

After passing nearly $3 trillion in fiscal stimulus as the pandemic unfolded in the second quarter, Federal government spending should increase considerably this year. However, because much of the incremental spending is on loans and transfer payments, some of the money will be saved by consumers or returned by borrowers, making its impact on economic growth uncertain.

Inflation was already slowing in the first quarter and plunged after “Safer at Home” orders prompted layoffs and much weaker consumer spending. For 12 months ending in May, the consumer price index (CPI) was up just 0.1% overall and 1.2% excluding food and energy. Through May, the PCE deflator was up 0.5% overall and 1.0% excluding food and energy. A dramatic decline in energy prices was primarily responsible for slower inflation. However, slack demand and sizable excess capacity should keep a lid on inflation for an extended period, which should leave the Federal Reserve firmly focused on its “maximum employment” objective.

In response to rapidly-emerging risks, the Federal Open Market Committee (FOMC) in March cut the federal funds rate target by 1.5% to its current level of 0–0.25%. FOMC members expect rates to remain near zero at least through 2022. The Fed also reinstated quantitative easing for the fourth time (QE4) since it was first used during the financial crisis, this time broadening its scope and making its size effectively unlimited. The Fed also reinstated or introduced new lending programs, including new facilities to purchase corporate and high-yield securities. Markets recovered substantially and financial conditions eased. Treasury yields fell sharply, with rates on 10- and 30-year Treasury bonds currently yielding about 0.7% and 1.4%, respectively.

These fiscal and monetary policy responses were designed to limit the economic impact from the COVID-19 pandemic. However, it’s inevitable that some households and businesses will be unable to meet their financial obligations, and we expect some credit strains to emerge over coming quarters. We expect rising delinquencies and defaults across borrower categories, but especially on commercial loans to more-leveraged nonfinancial companies, where borrowing has grown substantially over the past 7–8 years. Despite generally healthy balance sheets, some households are going to be unable to repay their debts, and we expect elevated delinquencies and charge-offs on consumer loans as well. Other sectors should see an increase in problem loans as well, but we think those will be less pronounced. Most financial companies in the U.S. have dramatically reduced their own leverage over the past decade and are better prepared for a downturn compared to the financial crisis in 2008. They possess both strong capital levels to support lending and healthy loan-loss reserves for potential defaults. Banks took large provisions for loan losses in the first quarter to get ahead of potential problems, and we expect another round of elevated provisions in the second quarter, albeit smaller than in Q1. Earnings at financial companies are likely to be muted as a result, but these actions strengthen their balance sheets and benefit debt and preferred investors.

While we anticipate the current recession will be short, the U.S. economy faces a long road to full recovery. Many businesses remain closed and others will continue to operate with social distancing and occupancy limits. Unemployment will remain elevated for some time. Additional COVID-19 outbreaks, which already have occurred as activity resumes, will prompt renewed limitations on business and individual activity – albeit more-targeted ones than during early phases of the pandemic. Nonetheless, we expect economic recovery will begin in the third quarter after a devastating Q2. Moreover, financial companies and utilities, which comprise the bulk of the Fund’s investments, are in a good position to ride out the storm and benefit from recovery. Just be prepared for a bumpy journey.

A Review of 2020 Dodd-Frank Bank Stress Tests

On June 25, The Federal Reserve released its 2020 large-bank Stress Test results. For the most part, they were as expected given the severity of the current healthcare crisis and global economic slowdown. This year’s “severely adverse scenario” assumptions included (1) U.S. unemployment rate climbing to a peak of 10% in 3Q21; (2) the 10-year Treasury yield slipping to 0.75% during 1Q20 and rising to 2.25% by the end of the stress-test period in 1Q22; (3) equity prices falling 50% through the end of 2020, accompanied by a rise in

volatility; and (4) house prices and commercial real estate prices experiencing steep declines of 28% and 35%, respectively, during the first nine quarters of the scenario. As a result, credit cards, commercial real estate and industrial loans showed the largest losses in the severely adverse scenario.

Our main takeaway from this year’s stress test is that most banks remain “well-capitalized” under both the traditional stress test and the Fed’s COVID-19 scenarios. All 33 banks “passed” the 2020 stress test. No banks breached minimum capital requirements during the stress period, although one would need to take small capital actions to do so. This year, in addition to its normal stress test, the Fed included downside scenarios which could result from the pandemic. Under all of these scenarios, all banks maintained capital buffers that were higher than the Fed’s required minimum, after capital actions.

Given heightened uncertainty from the coronavirus, the Fed is not allowing large banks to buy back common stock at least through 3Q20 and is limiting quarterly common stock dividends. Preferred dividends are not subject to any of these limitations, although, as always, they could be suspended without triggering an event of default.

For stress test purposes, the benchmark for a “Well-Capitalized” bank remains common equity Tier 1 (CET1) of 4.5% of risk-weighted assets plus a specific Global Systemically Important Bank Holding Company (GSIB) surcharge, where applicable. The Fed is implementing a new Stress Capital Buffer (SCB) requirement which will take effect in 4Q20. This new buffer was finalized in March 2020 and is independent of the COVID-19 pandemic. It will replace the capital conservation buffer (CCB). Currently, SCBs are either the same as or higher than CCBs they replaced. Importantly, higher levels of common equity capital should help support more senior securities, including preferreds. For quarterly reporting purposes, minimum CET1 for a “Well-Capitalized” bank is the sum of the aforementioned 4.5% plus GSIB surcharge, if any, plus the specific SCB assigned to each individual bank.

In addition, the Fed will require these large banks to update and resubmit capital plans later in 2020 using updated scenarios to reflect current stresses. In contrast to past years, the Fed will be more proactive and exercise greater vigilance over capital distributions to shareholders (perhaps on a quarter-to-quarter basis) during 2021 as a result of the aforementioned mid-cycle Comprehensive Capital Analysis and Review (CCAR).

Ultimately, the Fed is being deliberate and will assess economic conditions on a more-frequent basis over the next few quarters. Even if the virus and economic conditions worsen over the coming quarters and dividends are cut or suspended next year, such actions would help to conserve common equity capital, which should help support preferred investors.