PFO Flaherty & Crumrine Preferred and Income Opportunity Fund Inc

Flaherty & Crumrine Preferred and Income Opportunity Fund

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

Fiscal 2019 came to an end on November 30, 2019, closing out a fantastic year for preferreds and income securities. Total return on net asset value (“NAV”) was 2.8% for the fourth fiscal quarter and 20.4% for the full fiscal year. Total return on market price of Fund shares over the same periods was 1.8% and 19.6%, respectively.

The table below shows Fund NAV returns over various measurement periods. The table includes performance of two indices, Bloomberg Barclays U.S. Aggregate and S&P 500, as proxies for bond and stock markets, respectively. While neither is a benchmark for Fund performance, they provide context for returns on broad asset categories.

What a difference a year can make! The fourth quarter of 2018 produced dismal performance as markets worried about rate hikes and a possible recession. The Federal Reserve’s unexpected pivot in January 2019 on its outlook for future rate hikes and size of its balance sheet, however, prompted a sudden and dramatic mood change. As the year progressed and the Fed’s shift from tighter to more accommodative monetary policy became clear, markets gradually became desensitized to macro headlines. While trade and political uncertainty was abundant, the U.S. economy continued to progress despite these uncertainties, and interest rates settled into a relatively narrow range in the second half of 2019.

The Fed’s pivot was a strong signal to markets that it would be cautious on monetary policy, erring on the side of protecting a U.S. economy whose growth stood out among struggling global economies. With the Fed signaling that higher interest rates were unlikely near-term, markets began to price in lower rates as a dovish stance was in place for the foreseeable future. Indeed, interest rates moved substantially lower across the curve, and risk assets generally benefited from monetary policy easing. A global hunt for yield was once again in full effect.

Preferreds and contingent capital securities (“CoCos”) offer a yield advantage compared to senior debt (and most other fixed-income alternatives), primarily because they are subordinated in an issuer’s capital structure. Issuer credit quality in these markets has remained sound, partly due to a strong regulatory oversight

regime for most financial issuers. Preferreds and CoCos have been a natural fit for investors searching for yield. While once a very specialized market, preferreds and CoCos have benefited from a substantial broadening of the investor base. Even traditional bond funds now regularly add a layer of preferreds and CoCos to their portfolios to enhance yield and total return.

While investor demand has been strong, net new issuance this year has been measured. Issuers have largely entered a maintenance phase, where they issue at the margin to facilitate modest balance sheet growth, but where most issuance reflects refinancing of older securities to take advantage of lower rates. We believe this trend likely continues near-term, although CoCo issuance could pick up in the new year. Broad-based demand combined with limited supply have kept these markets well bid.

At risk of sounding like a broken record, bank preferreds and CoCos continued to be among the best sectors in 2019, and their consistent performance has been an important part of our investment thesis. Current bank regulation grew out of the financial crisis – and while we are a long way from the crisis, we don’t expect regulatory requirements to ease materially anytime soon. U.S. bank capital levels and loan loss provisions are high, earnings are healthy, and borrowers (broadly) are also healthy. Of course, not all banks are the same, and ongoing credit monitoring is important to our process. U.S. banks continue to be better positioned than their foreign counterparts on both earnings and capital, but European bank CoCos have been some of the best performers late in the year as Brexit finally appears to be on-track. As of November 30, U.S. bank holdings were 40.5% and foreign bank holdings were 16.2% of the Fund’s total managed assets.

All portfolio segments ended the year in positive territory, although the energy sector was volatile throughout most of the year. There has been much debate on the future of energy, from continued use of fossil fuels to increased adoption of renewable energy sources. At the same time, many Master Limited Partnerships (MLPs) have transformed from high-growth companies to more disciplined companies with much-simplified corporate structures. As a result, investor appetite for these companies’ securities has changed dramatically, and much of this exposure has migrated to different types of owners. Preferreds have continued to be a source of capital for MLPs, as they are uninterested in issuing common stock at depressed levels. The good news is that yields on these securities remain above-average in this space, and we believe a strategy of selective exposure will be successful. As of November 30, energy holdings were 7.4% of the Fund’s total managed assets.

A number of recent developments helped close 2019 on a positive note and should improve the outlook for 2020. U.K. elections provided a path to proceed finally with Brexit, and although much work remains over coming years, moving Brexit to resolution is positive for markets. China trade issues are much the same – a lot of work remains, and we may veer off course a few times, but both sides appear to be seeking common ground. Markets believe progress may finally be around the corner. As 2020 is a presidential election year in the U.S., we would caution that a long-term investment view is always prudent regarding political events. We believe the preferred and CoCo markets continue to offer long-term investors an attractive combination of good credit quality, high income and moderate interest-rate risk.

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

December 31, 2019

For the six months and one year periods ended November 30, 2019, the ICE BofAML 8% Constrained Core West Preferred & Jr Subordinated Securities Index^SM (P8JC)¹ returned 8.6% and 15.0%, respectively. This index reflects the 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).

Total Return on Market Price of Fund Shares

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. During the twelve-month period ended November 30, 2019, total return on market price of Fund shares was 19.6%.

Historically, the preferred securities market has experienced price volatility consistent with those of other fixed-income securities. However, since mid-2007 it has become clear that preferred-security valuations can move dramatically when there is volatility in financial markets. This volatility can lead to swings in both the NAV and market price of Fund shares. The chart below contrasts the relative stability of the Fund’s earlier period with the more recent volatility in both its NAV and market price. Many fixed-income asset classes experienced increased volatility over this period.

¹The ICE BofAML 8% Constrained Core West Preferred & Jr Subordinated Securities Index (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.

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 $12.32 on December 31^st and assuming its current monthly distribution of $0.0625 does not change, the annualized yield on market price of Fund shares is 6.1%. Of course, there can be no guarantee that the Fund’s dividend will not change based on market conditions.

U.S. Economic and Credit Outlook

The U.S. economy grew at a moderate pace in 2019. While fourth quarter numbers are not yet available, inflation-adjusted gross domestic product (real GDP) should be up about 2.3% in 2019. That would be modestly below economists’ consensus forecast of 2.7% growth entering 2019 and our expectation for a 2.5–3.0% expansion. Looking ahead, economists expect another slowdown in growth to 1.8% in 2020 and 2021. We are more optimistic for 2020, when we look for real GDP to expand by 2.0–2.5% on continued strength in consumer spending, a gradual recovery in housing and a modest rebound in business investment – all of which support a favorable credit outlook for the coming year.

The labor market was a source of strength once again for consumers. Payrolls were up by 2.1 million jobs (1.4%) and average hourly earnings rose by 2.9% over 12 months ending in December 2019. That contributed to a 4.9% jump in personal income over 12 months ending in November (latest data available). In turn, personal consumption expenditures (PCE) rose 3.9% year-over-year (YoY) in November, or 2.4% after inflation, and the savings rate moved up to 7.9%, well above its 20-year average of about 6%. With savings elevated, jobs plentiful and income growth strong, we think personal spending should equal or exceed 2019’s pace in 2020.

The housing market began to recover in 2019’s second half, with combined new and existing home sales consistently over 6 million units (at an annual rate) in each month since June. Residential investment turned positive in the third quarter after declining for six consecutive quarters, and we expect further gains in 2020. In contrast, business investment slowed to just 0.3% through the first nine months of 2019 after rising 5.9% in 2018. We are hopeful that a trade agreement expected to be signed between the U.S. and China in mid-January 2020 will help unleash investment that was deferred in 2019, although we expect only a modest rebound given lower capacity utilization rates in recent quarters. Finally, government spending rose a bit faster than overall GDP in 2019, and we expect a similar result in 2020.

Despite moderate economic growth, rising wages and higher import tariffs, inflation remained subdued. For 12 months ending in November, the consumer price index (CPI) was up 2.1% overall and 2.3% excluding food and energy. The Federal Reserve’s preferred inflation gauge, the PCE deflator, was up 1.5% overall and 1.6% excluding food and energy over 12 months ending in November – 0.4% below year-ago levels and well below the Fed’s 2% target for PCE excluding food and energy. We think inflation will edge up in 2020, but global excess capacity and some tariff rollbacks should prevent inflation from rising rapidly.

Monetary policy was active last year as the Fed shifted from rate hikes and a shrinking balance sheet in 2018 to rate cuts and a growing balance sheet in 2019. Financial conditions progressively loosened as the Federal Open Market Committee (FOMC) signaled a shift to significantly more accommodative monetary policy in January 2019; eliminated projections of additional rate hikes in March; delivered 25 bp rate cuts in July, September and October, bringing the fed funds rate target to 1.50–1.75%; ended balance sheet runoff in August; introduced stepped-up purchases of Treasury bills to address strains in money markets in September; and in December projected no rate hikes through the end of 2020. For now, the FOMC believes it has completed a “mid-cycle adjustment” to monetary policy that should help support economic growth and move inflation up toward its 2% target. These actions added up to considerably easier financial conditions, which helped boost prices of the Fund’s investments and lower its borrowing cost but also reduced reinvestment yields as the year progressed.

Looking ahead, today’s markets are pricing in one additional 25 bp rate cut by year-end 2020, with the fed funds rate stable around 1.3% through 2022 and moving gradually back up to around its current level (1.55%) thereafter. We expect the fed funds rate to hold steady in 2020. However, risk is mostly for lower rates if growth falters, as we think the Fed is unlikely to raise rates if the economy does better than expected. Markets have to incorporate that risk, and forward rates look about right to us today. However, if the Fed leaves rates steady as we expect, that means intermediate- and long-term rates should move modestly higher over the course of 2020.

With easier financial conditions and a steeper yield curve, credit conditions were favorable in 2019, especially for financial companies, which comprise over 70% of the preferred and contingent capital securities market. Leverage at U.S. financial companies has continued to decline since the financial crisis, and most of those companies have historically strong balance sheets and rising earnings. U.S. bank loan delinquencies and charge-offs were stable or lower in most lending categories in 2019, but they edged up in commercial and industrial loans. Loan-loss reserves remained strong at U.S. banks, though they are considerably thinner at many foreign banks. While not a near-term concern, rising leverage at nonfinancial companies is a longer-term risk we are monitoring.

Credit conditions and economic growth should remain broadly favorable in 2020 and benefit preferred securities. Credit spreads have room to narrow further in this environment, which should help offset a rise in intermediate- and long-term interest rates if economic growth outpaces economists’ subdued expectations for 2020. We have no doubt 2020 will be another interesting year – and we hope a good one for the Fund’s shareholders.

Federal Tax Advantages of 2019 Calendar Year Distributions

In calendar year 2019, approximately 87.3% of distributions made by the Fund was 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 17.2% 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 $122 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 39.3% 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 2020’s distributions may not be the same (or even similar) to 2019.

^§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 (unaudited).

**Securities distributing Qualified Dividend Income only (unaudited).

***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 November 30, 2019, these securities amounted to $62,132,180 or 27.7% 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 $142,003,610 at November 30, 2019.

⁽³⁾Represents the rate in effect as of the reporting date.

⁽⁴⁾All or a portion of this security has been rehypothecated. The total value of such securities was $64,624,689 at November 30, 2019.

⁽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

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