Avoid the Great Dividend Crunch

Companies are clinging to their cash these days.

It's not hard to see why. Cash is harder to come by in a recession. And this new mindset toward cash reverses a trend.

Shareholders, fed up with a long period of stingy dividends, put pressure on companies in recent years to sweeten the pot. Many companies did. This pleased investors. On the other hand, that cash had to come from somewhere. Instead of socking earnings into a rainy-day fund, many companies were cutting checks to shareholders.

Now, many of the companies that boosted dividends to please investors are now cutting dividends to save themselves. In the most recent quarter, 233 companies increased their dividends, a record low. That was down from 455 in the same period of 2008. Meanwhile, 250 companies cut their dividends in the quarter, the largest number in more than 50 years.

 

What’s interesting about this is that stocks have made huge gains since March. The S&P 500, for example, is up nearly +60% off its lows. But dividends haven't yet recovered.

There's reason to think it will be some time before they do.

One of the things driving large dividends was a belief that a company could always raise more money if need be. Executives of all but the largest and most credit-worthy companies now see that that's not always the case.

But even investors who look to bonds may have trouble sleeping as default rates continue to rise. In the first eight months of the year, there were 147 default events. A Bank of America-Merrill Lynch report estimates 40% of all U.S. junk bonds outstanding in late 2008 will default by 2013.

Safer bonds, of course, don't expose their owners to that kind of risk. And the safest bonds of all are the IOUs issued by the U.S. government.

While there are numerous funds in this space, BlackRock Enhanced Government Fund (NYSE: EGF) stands out as a long-term winner. This closed-end fund invests in debt and mortgage securities issued by government-sponsored mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

The fund pays a regular monthly distribution of $0.105 per share, or $1.26 annually, giving EGF a yield of more than 7%.

EGF's mandate is to invest at least 80% of its $190 million in assets in pristine U.S. government and agency securities. According to its latest quarterly report to the Securities and Exchange Commission, the fund had 64.1% of its portfolio in agency mortgage-backed securities and 11.2% in U.S. government debt. Only 1.0% of its holdings were below investment grade.

The portfolio has an average duration of about 2.25 years, which means the holdings will mature and the fund’s principal will be returned in about nine quarters. This helps protect the portfolio against rising interest rates. If interest rates rise in the next couple years, the fund can re-invest at the higher rates.