DFP Flaherty and Crumrine Dynamic Pfd and Income Fund Inc

Semi-Annual Report
May 31, 2022

Flaherty & Crumrine Dynamic Preferred and Income Fund

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

Like most other fixed-income securities, preferred and contingent-capital (“CoCo”) security prices were markedly lower to start the year as investors faced challenging news and market conditions. Total return¹ on net asset value (“NAV”) was -6.6% for the second fiscal quarter² and -11.0% for the first half of the fiscal year. Total return on market price of Fund shares over the same periods was -7.2% and -11.5%, respectively.

(1)Since inception on May 29, 2013.

(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.

A new wall of worry began to build as we turned calendars to 2022, with inflation levels unseen in over 40 years, concern that Federal Reserve (Fed) policy is behind the curve, and an unprovoked invasion of Ukraine by Russia that began in late February. These worries advanced as interest rates moved higher and the yield curve flattened. Credit spreads widened as mutual funds and exchange-traded funds experienced sizable outflows, and volatility in all markets increased. Spikes in commodity prices related to the Russia-Ukraine war have only heightened inflation concerns. Focus more recently has shifted to consequences of aggressive Fed policy necessary to fight inflation, including the possibility of a recession.

Economists and the Fed had expected inflation to pick up in 2021 as the economy recovered from recession and the COVID-19 pandemic. However, inflation turned out to be much higher, broader, and more persistent than anticipated. Although monetary policy did not spark this inflation — a rapid, global recovery in demand combined with supply constraints did that — it remained very loose. Sharply negative real interest rates and rapid money supply growth accommodated higher inflation. Higher inflation was a policy choice by the Fed as it sought to return employment to pre-pandemic levels. It has turned into a policy mistake — one that the Fed is now attempting to address. The Fed hiked rates by 0.25% in March, 0.50% in May, and another 0.75% in June, and it signaled an aggressive cycle of rate hikes that are projected to bring the fed funds rate to about 3.4% and 3.8% at year-end 2022 and 2023, respectively.

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

²March 1, 2022 - May 31, 2022

Portfolio performance in the fiscal year’s first half was driven by higher interest rates and wider credit spreads. Although portfolio interest-rate duration was intermediate, the move in interest rates has been substantial. Our 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 — has resulted in less overall impact from higher rates than some other segments of preferred and credit markets. For comparison, Bloomberg US Long Credit¹ total return over the same period ending May 31, 2022 was -19.3%, and Bloomberg US Aggregate Bond total return was -9.2% — both are un-levered indices. If reset today, many of the securities held by the Fund would set at higher rates than their initial front-end coupons, although many will not reset for another 2-5 years.

The table below shows benchmark interest rates and cumulative changes since last fiscal year end. The impact of interest-rate duration on the portfolio was largely as expected given these moves (i.e., “intermediate”). However, dramatic credit spread widening was unexpected and had an additional negative impact on performance during the period. Markets loath uncertainty, and much of the move in credit spreads is a result of uncertainty and fear. Market trading depth has been thin and liquidity at a premium, resulting in markets moving lower most days as investors continued to reduce exposure and funds sold securities to meet outflows.

We continue to believe credit quality is a highlight of the preferred and CoCo market, and investors are now earning much higher yields for these credits. Banks remain very well capitalized, highly regulated, and most are asset-sensitive — which means earnings will increase with higher interest rates. Please see our separate discussion topic on recent bank stress test results, as the credit outlook is very positive. 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, including pipeline issuers 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 all 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.

The yield curve has flattened, driven by higher expected short-term interest rates consistent with a Fed tightening cycle. While this should eventually be positive for coupons of most fixed-reset or floating securities, it also means leverage costs are increasing immediately. The Fund remains in a transition stage in terms of distributable income, as top-line income has declined in recent years with issuer redemptions and lower reinvestment rates, while leverage costs are rising rapidly from very low levels and will continue to increase while the Fed hikes rates. Earlier in the year, the Fed expected to move gradually, but its stance changed in response to inflation data, and that resulted in much larger hikes early in the cycle. As shown

¹The 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.

in the table above, 1-month LIBOR, the benchmark rate for the Fund’s leverage, has already increased by over 165 basis points (66 bp of that in June alone) and is forecasted to continue increasing near-term. The Fund will generate lower distributable income until leverage costs stabilize and/or portfolio income levels gradually adjust upward. Consequently, we expect further reductions in common stock dividends over coming months to keep pace with these changes in distributable income. The margin between portfolio income and leverage costs will eventually reach an inflection point and likely begin to expand once again, much like it has done over previous cycles, but it will take time for everything to adjust. Please see our separate discussion topic on the Fund’s use of leverage and why it remains a positive contributor to distributable income, despite changes in margin over time.

Fed policy has and likely will continue to tighten financial conditions, and it should be successful in reducing aggregate demand and inflation. However, forecasting the timing and impact of other macroeconomic issues such as supply-chain disruptions, COVID policies, and the Russia-Ukraine war are nearly impossible. Resolution of any one of these issues, let alone all of them, is likely to have a dramatic positive impact on inflation expectations and market sentiment. Preferred and CoCo issuers, along with U.S. consumers broadly, are in a strong position to weather this storm — but time is the only remedy for macroeconomic issues outside the Fed’s purview. Holding or adding to investments when markets are lower and sentiment is 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.

We encourage you to read the discussion topics that follow, as we dig deeper into subjects of interest to shareholders. In addition, the Fund’s website, www.preferredincome.com, has been completely redesigned and offers timely and important information. If you haven’t visited recently, please take a moment to explore the new design and content.

Sincerely,

The Flaherty & Crumrine Portfolio Management Team

June 30, 2022

For the six-month period ended May 31, 2022 the ICE BofA 8% Constrained Core West Preferred & Jr Subordinated Securities Index^SM (P8JC)^1,2 (Benchmark Index) returned -8.7%. 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%.

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 produced mixed results in the first half of 2022, with strong nominal growth eroded by the highest inflation in decades. Gross domestic product adjusted for inflation (“real GDP”) fell 1.6% in the first quarter as a wider trade deficit and a slower pace of inventory accumulation more than offset a 2.0% rise in domestic final sales. While the advance estimate of second quarter GDP will not be available until late July, economists in the latest Federal Reserve Bank of Philadelphia’s Livingston Survey forecast real GDP growth of 0.5% in the first half of 2022, which would imply a 2.6% gain in Q2. Before adjusting for inflation, nominal GDP was much higher: 6.6% in Q1 and an estimated 8.1% in Q2. For the second half of 2022, these economists expect real GDP to expand by 2.1%.

Employment has grown rapidly so far in 2022, pushing the unemployment rate down to 3.6% in May from 3.9% in December 2021. Demand for workers remains strong, with 1.9 job openings for each unemployed person as of April. Although hiring is likely to slow from this very rapid pace, we expect it to remain solid in the second half. Higher hourly pay and rising employment drove solid gains in wage and salary income so far in 2022, although overall personal income failed to keep pace with inflation as transfer payments slowed sharply. Real personal consumption expenditures (PCE) slowed to 1.8% in Q1 from 2.5% a quarter earlier, as consumers dipped into savings and increased borrowing. Recent increases in gasoline and food prices probably forced households to devote a larger share of income to those items, and real consumer spending growth is likely to be similarly slow in Q2.

Home sales fell as soaring prices and mortgage rates cooled demand, while high inflation turned strong nominal residential investment into only a 0.4% real gain in Q1; it probably turned negative in Q2. Industrial output rose 7.0% in Q1, with even faster gains in April and May. Rapidly rising output pushed capacity utilization up to 79% in May, its highest level since 2018. Real business investment rose 10.0% in Q1, and economists expect a gain of 7.3% in Q2. While order growth has remained sturdy, business confidence has slipped in response to tighter monetary policy (discussed below). We expect slower growth in both industrial output and business investment in the second half.

Strong demand and, until quite recently, accommodative monetary policy drove inflation sharply higher in 2022. Compared to the same month a year earlier, the consumer price index (CPI) reached a high of 8.6% in May, and the PCE deflator peaked at 6.6% in March. Inflation broadened beyond food and energy prices, and the core CPI (excluding food and energy) rose to a peak of 6.5% YoY in March, while the core PCE deflator reached a high of 5.3% YoY in February. Although those levels probably mark the peak in core inflation for this cycle, we do not expect to see major progress on inflation until the fourth quarter.

High inflation prompted a sharp turn in monetary policy. The Fed hiked the fed funds rate by 150 basis points to a target range of 1.50%-1.75%, and, unlike the Fed’s mid-June projections, markets as of June 30 were pricing in a fed funds rate of 3.4% by year-end, a peak at 3.5% in mid-2023, and a decline to 2.9% at year-end 2023. The Fed also ended quantitative easing in March and, in June, began to reduce its securities holdings by up to $30 billion Treasuries and $17.5 billion of mortgage-backed securities per month. The Fed plans to double its monthly portfolio runoff starting in September. These actions combined to drive up benchmark interest rates and the U.S. dollar, widen credit spreads, and push down common equity prices — sharply tightening financial conditions.

To bring inflation down, the Fed must tighten financial conditions and slow money growth to levels that reduce aggregate demand and bring it into (noninflationary) balance with supply. Because monetary policy acts with a lag and has limited impact on the economy’s supply side, it will be very difficult, although not impossible, for the Fed to reduce inflation from current levels back toward its 2% long-term target without overshooting. We expect the economy to continue its expansion this year, although recession risk will increase in 2023.

Despite a challenging economic backdrop, fundamental credit quality remains healthy. The ratio of debt to GDP has continued to decline across most sectors of the economy. Household and financial business balance sheets look especially strong. Business bankruptcy filings, household and business debt service, and bank loan delinquencies and charge-offs all remain historically low. Financial companies, which are the largest issuers in the preferred market, should

benefit from higher interest rates. Moreover, as recent “stress test” results from the largest U.S. banks demonstrate, they have the capital, earnings, and reserves to manage strains that a recession could bring. We believe today’s higher yields on preferred and CoCo securities offer a foundation for potentially better returns ahead.

A Review of 2022 Dodd-Frank Bank Stress Tests

On June 23, the Federal Reserve released its 2022 large-bank Dodd-Frank Act stress test results. They were mostly as expected, and all 33 banks “passed” the 2022 stress test amid the prevailing global economic uncertainty. Under the 2022 “severely adverse scenario” — which factored in unemployment peaking at 10% in 3Q23, real GDP down 6.2%, equities down 55%, house prices down 28.5% and commercial real estate down 40% — the average minimum common equity Tier 1 (CET1) capital ratio for this year’s 33 bank participants was 9.7% versus 10.6% in the June 2021 test (only 23 banks took the test last year). The results of this year’s stress test demonstrate that large U.S. banks remain “well-capitalized,” reporting high capital levels, and no bank breached minimum capital requirements during the two-year stress period.³ Under all scenarios, the 33 large banks maintained capital buffers that were significantly above the Fed’s required minimum, after capital actions. Large U.S. banks are well prepared for a recession, should one arrive, over the next several years.

The Fed also conducted its 2022 Comprehensive Capital Analysis and Review (CCAR) to evaluate bank capital plans in light of the stress tests. Our main CCAR takeaway is that banks continue to exercise discipline regarding common shareholder returns. At the same time, banks maintain flexibility to increase dividends and share repurchases if earnings accelerate during 2H22 as projected. Most money center banks will be subject to larger SCB requirements effective October 1, 2022, adding to those banks’ CET1. Meanwhile, regional banks have more flexibility to raise quarterly dividends and maintain, or even increase, share buyback programs following this year’s stress test, given an expected recovery in commercial and industrial lending and sizeable loan loss reserves already in place. Given increased risk from monetary policy tightening, we expect all banks to maintain conservative capital and loan-loss positions over coming quarters, which should continue to support preferred investors.

Use of Leverage and Monthly Distributions to Fund Shareholders

When it comes to projecting income available to shareholders in future years, the elephant in the room today is the expected cost of leverage. Use of leverage is an important part of the Fund’s strategy for generating high current income, and we could not produce the Fund’s current level of income without it. Leverage costs, which for the Fund are currently 1-month LIBOR + 0.80%, reset monthly, remained low throughout 2020 and 2021. Leverage costs have increased rapidly this year, consistent with the Fed’s more-aggressive path for rate hikes.

During periods of higher leverage costs, there are two questions that shareholders might ask.

If you expect the cost of leverage to increase, why not remove (or at least reduce) leverage from the Fund?

The answer is twofold. First, so long as the cost of leverage is below income earned on the portfolio — which has almost always been the case — income available to shareholders will be higher with leverage than it would be without leverage. Second, following the same logic, removing, or substantially reducing, leverage today would result in a material reduction in the current dividend rate, given current wide spreads between yields on preferred securities and cost of leverage. So even if leverage costs increase, benefits to distributable income over time can still be substantial as long as leverage costs do not exceed portfolio yield.

³For 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.

If you think short-term rates are going to increase, why don’t you hedge the cost of leverage?

In general, hedging is done for two reasons: first, to reduce absolute exposure to a particular risk; and second, to reduce volatility associated with a particular risk. When considering a hedge against a rise in short-term rates, one must weigh cost versus benefit. If we knew exactly when rates would rise and by how much, then we could evaluate the explicit costs and determine if it would be a winning trade.

Since we don’t know the exact timing or magnitude of higher short-term interest rates, a hedge is really another investment decision — one in which we would be betting that the cost of a hedge now (in the form of higher leverage costs today) will be lower than the actual cost of leverage (unhedged) over the hedge’s timeframe. In other words, the Fund’s distributable income would be lower today if we were to hedge the cost of leverage very far into the future. This is because today’s upward-sloping yield curve means the market already expects rates in the future to be higher, so that expected cost is reflected in hedging cost today.

We acknowledge this is complicated, but to simplify: hedging the cost of leverage today would result in lower income today — and may or may not result in improved return (relative to no hedge) in the future. A hedge is a bet on the timing and magnitude of rate increases relative to the market’s pricing of these risks. There are times when hedging leverage would have added to distributable income (e.g., the last several quarters) and other times when it would have reduced it (e.g., most of the prior decade). However, it is very difficult to judge when those periods lie ahead. We do know that the yield curve in most periods is positively sloped, which means hedging leverage cost would reduce distributable income immediately. For now, we have decided it is best to take short-term rates as they come.