UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSRS
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT
INVESTMENT COMPANIES
Investment Company Act file number 811-21793
Name of Fund: Enhanced Government Fund, Inc.
Fund Address: P.O. Box 9011
Princeton, NJ 08543-9011
Name and address of agent for service: Robert C. Doll, Jr., Chief Executive
Officer, Enhanced Government Fund, Inc., 800 Scudders Mill Road,
Plainsboro, NJ, 08536. Mailing address: P.O. Box 9011, Princeton,
NJ, 08543-9011
Registrant's telephone number, including area code: (609) 282-2800
Date of fiscal year end: 12/31/06
Date of reporting period: 01/01/06 - 06/30/06
Item 1 - Report to Stockholders
Semi-Annual Report
June 30, 2006
Enhanced Government
Fund, Inc.
(BULL LOGO) Merrill Lynch Investment Managers
www.mlim.ml.com
Mercury Advisors
A Division of Merrill Lynch Investment Managers
www.mercury.ml.com
Enhanced Government Fund, Inc. seeks to provide stockholders with current
income and gains by investing primarily in a portfolio of U.S. Government
securities and U.S. Government Agency securities, including U.S. Government
mortgage-backed securities, that pay interest in an attempt to generate
current income and by employing a strategy of writing (selling) call options
on individual or baskets of U.S. Government or U.S. Government Agency
securities or other debt securities held by the Fund in an attempt to generate
gains from option premiums.
This report, including the financial information herein, is transmitted to
shareholders of Enhanced Government Fund, Inc. for their information. It is
not a prospectus. Past performance results shown in this report should not be
considered a representation of future performance. Statements and other
information herein are as dated and are subject to change.
A description of the policies and procedures that the Fund uses to determine
how to vote proxies relating to portfolio securities is available (1)
without charge, upon request, by calling toll-free 1-800-637-3863; (2) at
www.mutualfunds.ml.com; and (3) on the Securities and Exchange Commission's
Web site at http://www.sec.gov. Information about how the Fund voted proxies
relating to securities held in the Fund's portfolio during the most recent
12-month period ended June 30 is available (1) at www.mutualfunds.ml.com and
(2) on the Securities and Exchange Commission's Web site at http://www.sec.gov.
Enhanced Government Fund, Inc.
Box 9011
Princeton, NJ 08543-9011
(GO PAPERLESS LOGO)
It's Fast, Convenient, & Timely!
To sign up today, go to www.icsdelivery.com/live.
Enhanced Government Fund, Inc.
Announcement to Shareholders
On February 15, 2006, BlackRock, Inc. ("BlackRock") and Merrill Lynch & Co.,
Inc. ("Merrill Lynch") entered into an agreement to contribute Merrill Lynch's
investment management business, Merrill Lynch Investment Managers, L.P. and
certain affiliates (including Fund Asset Management, L.P. and Merrill Lynch
Investment Managers International Limited), to BlackRock to create a new
independent company ("New BlackRock") that will be one of the world's largest
asset management firms with over $1 trillion in assets under management (based
on combined assets under management as of June 30, 2006) (the "Transaction").
The Transaction is expected to close at the end of the third quarter of 2006,
at which time the new company will operate under the BlackRock name. The
Fund's Board of Directors has approved a new investment advisory agreement
with BlackRock Advisors, Inc. or its successor on substantially the same terms
and for the same advisory fee as the current investment advisory agreement
with the Investment Adviser. If the new agreement is approved by the Fund's
shareholders, BlackRock Advisors, Inc. or its successor is expected to become
the investment adviser of the Fund upon the closing of the Transaction.
Fundamental Periodic Repurchase Policy
The Board of Directors approved a fundamental policy whereby the Fund has
adopted an "interval fund" structure pursuant to Rule 23c-3 under the
Investment Company Act of 1940, as amended (the "1940 Act"). As an interval
fund, the Fund will make annual repurchase offers at net asset value (less
repurchase fee not to exceed 2%) to all Fund shareholders. The percentage of
outstanding shares that the Fund can repurchase in each offer will be
established by the Fund's Board of Directors shortly before the commencement
of each offer, and will be between 5% and 25% of the Fund's then outstanding
shares.
The Fund has adopted the following fundamental policy regarding periodic
repurchases:
(a) The Fund will make repurchase offers at periodic intervals pursuant to
Rule 23c-3 under the 1940 Act.
(b) The periodic interval between repurchase request deadlines will be
approximately 12 months.
(c) The repurchase request deadline for each repurchase offer will be 14 days
prior to the second Friday in December, commencing in December 2006;
provided, that in the event that such day is not a business day, the
repurchase request deadline will be the subsequent business day.
(d) The maximum number of days between a repurchase request deadline and the
next repurchase pricing date will be 14 days; provided that if the 14th
day after a repurchase request deadline is not a business day, the
repurchase pricing date shall be the next business day.
The Board of Directors may place such conditions and limitations on a
repurchase offer as may be permitted under Rule 23c-3. Repurchase offers may be
suspended or postponed under certain circumstances, as provided in Rule 23c-3.
Availability of Quarterly Schedule of Investments
The Fund files its complete schedules of portfolio holdings with the Securities
and Exchange Commission ("SEC") for the first and third quarters of each fiscal
year on Form N-Q. The Fund's Forms N-Q are available on the SEC's Web site at
http://www.sec.gov. The Fund's Forms N-Q may also be reviewed and copied at the
SEC's Public Reference Room in Washington, DC. Information on the operation of
the Public Reference Room may be obtained by calling 1-800-SEC-0330.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
A Letter From the President
Dear Shareholder
By now, you have probably heard of the important changes unfolding at
Merrill Lynch Investment Managers ("MLIM"). We have been communicating
with shareholders, via letters like this and in a detailed proxy mailing,
about MLIM's impending union with another highly regarded investment
manager - BlackRock, Inc. ("BlackRock"). This transaction marks the next
chapter in MLIM's growth story and, we believe, will be a benefit to our
investors.
MLIM, a division of Merrill Lynch with over $583 billion in assets under
management, is a leading investment manager offering more than 100 investment
strategies in vehicles ranging from mutual funds to institutional portfolios.
BlackRock, with $464.1 billion in assets under management, is one of the
largest publicly traded investment management firms in the United States
managing assets on behalf of institutional and individual investors worldwide
through a variety of equity, fixed income, liquidity and alternative investment
products. At the completion of the transaction, which is expected by the end
of third quarter 2006, the resultant firm will be a top-10 investment manager
worldwide with over $1 trillion in assets under management.*
The combined company, to be known as BlackRock, will provide a wide selection
of high-quality investment solutions across a range of asset classes and
investment styles. The organization will have over 4,500 employees in 18
countries and a major presence in key markets worldwide. MLIM and BlackRock
possess complementary capabilities that together create a well-rounded
organization uniting some of the finest money managers in the industry. The
firms share similar values and beliefs - each strives for excellence in all
areas, and both make investment performance their single most important
mission. As such, our combination only reinforces our commitment to
shareholders.
Most of MLIM's investment products - including mutual funds, separately
managed accounts, annuities and variable insurance funds - eventually will
carry the "BlackRock" name. This will be reflected in newspaper and online
information sources beginning in October. Your account statements will reflect
the BlackRock name beginning with the October month-end reporting period.
Unless otherwise communicated via a proxy statement, your funds will maintain
the same investment objectives that they do today. Importantly, the MLIM/
BlackRock union will not affect your brokerage account or your relationship
with your financial advisor. If you are a client of Merrill Lynch, you will
remain a client of Merrill Lynch.
As always, we thank you for entrusting us with your investment assets. We look
forward to continuing to serve your investment needs with even greater
strength and scale as the new BlackRock.
Sincerely,
(Robert C. Doll, Jr.)
Robert C. Doll, Jr.
President and Chief Investment Officer
Merrill Lynch Investment Managers
* $1.047 trillion in assets under management as of June 30, 2006.
Data, including assets under management, are as of June 30, 2006.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
A Discussion With Your Fund's Portfolio Managers
The Fund continued to provide shareholders with an attractive level of monthly
income while also outperforming its benchmark on a total return basis in what
was a challenging period for fixed income investments.
What is the Fund's investment objective?
The Fund seeks to provide shareholders with current income and gains through
investment primarily in a portfolio of U.S. government and U.S. government
agency securities - including U.S. government mortgage-backed securities - that
pay interest. The Fund also will write (sell) call options on individual
securities or baskets of U.S. government and U.S. government agency securities
or other debt securities in an attempt to generate gains from option premiums.
Under normal market conditions, the Fund will invest at least 80% of the value
of its net assets, plus the amount of any outstanding debt securities or
borrowings for investment purposes, in U.S. government and U.S. government
agency securities. The Fund also may invest up to 20% of its net assets in
non-U.S. government debt securities of foreign or domestic issuers. As part
of its option strategy, the Fund also may write options on these other debt
securities.
How did the Fund perform during the period in light of the existing market
conditions?
For the six-month period ended June 30, 2006, the Common Stock of Enhanced
Government Fund, Inc. had net annualized yields of 7.62% and 7.95%, based on a
period-end per share net asset value of $18.52 and a per share market price of
$17.75, respectively, and $.700 per share income dividends. Over the same
period, the total investment return on the Fund's Common Stock was +.33%,
based on a change in per share net asset value from $19.18 to $18.52, and
assuming reinvestment of all distributions. The Citigroup Government and
Mortgage Index returned -.57% for the same period.
It was a challenging period for fixed income investment. The Federal Reserve
Board (the Fed), in its continuing effort to stave off inflation, advanced its
measured program of monetary tightening. During this period, the Fed increased
the federal funds rate four times, bringing the target short-term interest
rate from 4.25% to 5.25%. In all, the Fed has raised the federal funds rate 17
times since June 2004, for a total increase of 4.25%. In response to the most
recent interest rate hikes, and despite some uncertain rhetoric from new Fed
Chairman Ben Bernanke, yields rose all along the curve. After flattening
considerably during the course of the Fed's interest rate-hiking campaign, the
Treasury yield curve inverted intermittently throughout the past six months,
with short-term yields exceeding longer-term yields.
Because bond prices move in the opposite direction of yields, the rising
interest rates exerted significant downward price pressure on fixed income
securities. Over the semi-annual period, six-month Treasury bill yields rose
87 basis points (.87%) to 5.24% while 10-year yields rose 76 basis points to
5.15%. These yields reflect the inverted shape of the curve at period-end.
Amid these conditions, many fixed income asset classes posted negative
returns. The Fund's benchmark, the Citigroup Government and Mortgage Index,
was no exception. The Fund, however, was able to post a modest positive total
return and provided shareholders with attractive monthly income. This was
largely due to our options-writing strategy, which helps to cushion the
portfolio from the negative price impact associated with rising interest
rates. The Fund sells call options on individual securities or baskets of
securities in an effort to generate gains from the premiums that the buyer
pays on the options. During the period, most of the options we wrote expired
"worthless," allowing us to keep the premium on the underlying security and
thereby producing additional return for the portfolio above that offered by
the underlying securities. We also saw a slight increase in the level of
implied volatility in the market, which is a positive for the Fund. The
increased volatility meant we received slightly higher premiums for the
options we were selling. This, combined with the bear market, contributed to
good relative results. Whereas other inter-mediate-duration fixed income
products declined as rates rose, the options-writing strategy helped the Fund
to hold steady while also adding incremental yield.
For a description of the Fund's total investment return based on a change in
the per share market value of the Fund's Common Stock (as measured by the
trading price of the Portfolio's shares on the New York Stock Exchange), and
assuming reinvestment of dividends, please refer to the Financial Highlights
section of this report. As a closed-end fund, the Fund's shares may trade in
the secondary market at a premium or discount to the Fund's net asset value.
As a result, total investment returns based on changes in the market value of
the Fund's Common Stock can vary significantly from total investment returns
based on changes in the Fund's net asset value.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
What changes were made to the portfolio during the period?
The Fund's distribution yield is derived by combining the income from its
underlying securities with the premiums received from the options-writing
strategy. As interest rates rose during the six-month period, we wanted to
structure the portfolio so that the majority of the yield was being generated
by the underlying securities in the portfolio, with supplemental income from
the options premiums. We started the period with an options position of about
80%. That reached a high of 94% in January and ended the period at 69%.
To augment yield within our portfolio of underlying securities, we reduced
exposure to Treasury issues in favor of agency commercial mortgage-backed
securities (CMBS). CMBS generate incremental yield over Treasury securities
without the maturity variability of residential mortgages. We also increased
our use of the portfolio's non-agency bucket by establishing a position in
AAA-rated mortgage-backed securities. We believe this should enhance yield in
the portfolio without increasing risk appreciably given the high credit
quality of the securities added. We ended the period with roughly a 13%
commitment to non-agency securities, and are permitted to invest up to 20%.
We also made what we would term a defensive move on interest rates. Based on
our belief that the market was leaning toward a continued rise in rates, we
sold some of our holdings of residential mortgages in favor of hybrid
adjustable-rate mortgages (ARMs) and collateralized mortgage obligations
(CMOs). The residential mortgage market and the CMO market move in similar
directions, but at times the residential market can become rich or cheap
relative to the CMO market. Early in the year, we took the opportunity to sell
residential mortgages, which were expensive, and bought the cheaper CMOs,
believing that residential mortgages would underperform. CMOs are pools of
mortgages structured to provide certain cash flow based on the prepayments on
the underlying collateral. We purchased both the underlying collateral and the
CMOs in order to establish more stable cash flow. Another advantage of hybrid
ARMs and CMOs is that they tend to withstand interest rate volatility better
than residential mortgages and also outperform as the yield curve steepens. As
such, we are beginning to prepare the portfolio for an eventual end to Fed
tightening and a re-steepening of the yield curve.
In terms of duration, the Fund's underlying portfolio (excluding the options)
remained close to the benchmark duration for much of the period. We use the
options-writing strategy as a protection against rising rates, so we tend to
maintain a neutral duration rather than using a short or long duration
position as an interest rate play.
Finally, we wrote some out-of-the-money options during the period. In the case
of out-of-the-money options, the strike price is greater than the price of the
underlying security. (The assumption is that the price of the underlying
security will rise slightly.) This provided us with some flexibility to
participate in any small rally in bond prices.
In all, the Fund continued to provide shareholders with a consistent level of
monthly income, at a monthly distribution rate of approximately 7%.
How would you characterize the Fund's position at the close of the period?
The Fed appears to be closing in on the end of its two-year monetary
tightening campaign. This may require us to further limit our options-writing
strategy if it appears that a bond market rally is imminent. We also may seek
some protection against a bull market by buying some longer-dated out-of-the-
money call options. While we do not expect such a scenario in the immediate
future, we are particularly mindful of the risks within this portfolio.
We continue to look for value in the non-agency area as we further our efforts
to increase yield via the underlying securities in the portfolio. This would
allow us to write fewer options while maintaining the Fund's attractive
distribution yield, as well as potentially reducing overall risk in the
portfolio given the inherent risk associated with an options-writing strategy.
Thomas F. Musmanno
Vice President and Portfolio Manager
Frank Viola
Vice President and Portfolio Manager
July 18, 2006
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Schedule of Investments (in U.S. dollars)
Face Interest Maturity
Issue Amount Rate Date(s) Value
Government & Agency Obligations--25.2%
Fannie Mae $ 5,000,000 2.375% 2/15/2007 $ 4,904,480
3,500,000 5.25 4/15/2007 3,491,750
3,050,000 6.375 6/15/2009 3,125,814
2,000,000 6.625 9/15/2009 2,067,696
1,375,000 7.25 1/15/2010 1,453,045
3,000,000 6.00 5/15/2011 3,064,659
Federal Farm Credit Bank 3,500,000 4.55 6/08/2020 3,111,013
Federal Home Loan Bank System 1,000,000 4.125 10/19/2007 982,832
Freddie Mac 1,500,000 5.875 3/21/2011 1,511,974
1,000,000 6.25 7/15/2032 1,085,590
U.S. Treasury Bonds 789,000 8.125 8/15/2019 998,887
1,220,000 8.50 2/15/2020 1,595,531
2,500,000 6.25 5/15/2030 2,831,640
1,500,000 4.50 2/15/2036 1,344,962
U.S. Treasury Notes 8,000,000 6.50 10/15/2006 8,026,248
11,500,000 3.625 6/30/2007(e) 11,316,265
1,990,000 3.00 2/15/2008 1,922,760
4,800,000 8.75 5/15/2020 6,412,123
Total Government & Agency Obligations (Cost--$60,765,205)--25.2% 59,247,269
Government Agency Mortgage-Backed Securities**--58.6%
Fannie Mae Guaranteed Pass-Through Certificates 9,481,622 4.50 4/01/2020 - 11/01/20 8,962,457
1,965,247 4.66 7/01/2010 1,894,647
6,620,622 4.681 2/01/2013 6,407,877
9,257,028 5.32 10/01/2035 (a) 9,066,846
21,513,315 5.50 11/01/2020 - 11/01/2035 20,732,052
2,857,899 5.707 2/01/2012 2,901,875
2,517,532 6.00 10/01/2035 2,479,832
5,679,479 6.60 1/01/2011 5,822,739
Fannie Mae Trust 2006-58-DA 2,927,000 5.50 9/25/2025 2,906,382
2006-37-DB 3,000,000 6.00 4/25/2035 2,964,145
Freddie Mac Mortgage Participation Certificates 1,121,942 4.50 5/01/2034 1,023,009
4,923,337 5.00 5/01/2020 4,740,117
15,785,493 5.00 11/01/2035 14,753,555
4,807,201 5.01 10/01/2035 (a) 4,679,509
706,471 5.50 10/01/2035 679,000
2,713,214 6.00 10/01/2035 2,673,049
5,734,327 6.50 9/01/2035 - 10/01/2035 5,769,158
Freddie Mac Multiclass Certificates 2958-MD 5,000,000 5.50 1/15/2031 4,875,193
3136-PD 1,674,840 6.00 12/15/2034 1,649,088
3173-PE 3,000,000 6.00 4/15/2035 2,974,219
Ginnie Mae MBS Certificates 3,212,508 5.00 11/15/2035 3,041,349
3,667,823 5.50 11/15/2035 3,556,815
Ginnie Mae Trust 2006-30-IO 9,000,000 0.80 5/16/2046 (g) 526,528
2006-5-A 3,955,116 4.421 7/16/2029 3,805,051
2006-3-C 10,000,000 5.235 4/16/2039 (a) 9,308,577
2005-87-C 10,000,000 5.328 9/16/2034 (a) 9,635,417
Total Government Agency Mortgage-Backed Securities (Cost--$141,581,398)--58.6% 137,828,486
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Schedule of Investments (continued) (in U.S. dollars)
Face Interest Maturity
Issue Amount Rate Date(s) Value
Non-Government Agency Mortgage-Backed Securities**--13.2%
Banc of America Alternative Loan Trust Series 2005-10
Class 1CB3 $ 1,245,000 5.50 % 11/25/2035 $ 1,167,806
CS First Boston Mortage Securities Corp. Series 2005-11
Class 6A5 2,130,395 6.00 12/25/2035 2,125,595
CitiMortgage Alternative Loan Trust Series 2006-A2 Class A2 2,478,600 6.00 5/25/2036 2,405,791
Credit Suisse Mortgage Capital Certificates Series 2006-C3
Class A3 2,850,000 5.828 6/15/2038 (a) 2,849,430
Greenwich Capital Commercial Funding Corp. Series 2006-GG7
Class A4 1,500,000 6.11 6/10/2016 1,501,743
JPMorgan Chase Commercial Mortgage Securities Corp.:
Series 2006-CB14 Class A2 1,400,000 5.437 12/12/2044 1,382,992
Series 2006-CB15 Class A4 2,500,000 5.814 6/12/2043 (a) 2,480,975
Series 2006-LDP7 Class A4 2,000,000 5.876 4/15/2045 (a) 1,997,000
JPMorgan Mortgage Trust Series 2005-A2 Class 4A1 4,364,896 5.209 4/25/2035 (a) 4,189,637
LB-UBS Commercial Mortgage Trust Series 2004-C6 Class A3 5,000,000 4.547 8/15/2029 4,764,201
Residential Funding Mortgage Security I:
Series 2006-S1 Class IA5 1,677,000 5.25 1/25/2036 1,638,557
Series 2006-S3 Class A2 1,952,000 5.50 3/25/2036 1,821,359
Wells Fargo Mortgage Backed Securities Trust, Series
2005-13 Class A1 2,838,903 5.00 11/25/2020 2,751,612
Total Non-Government Agency Mortgage-Backed Securities (Cost--$31,404,642)--13.2% 31,076,698
Beneficial
Interest
Short-Term Securities--8.3%
$ 8,291,146 Merrill Lynch Liquidity Series, LLC Cash Sweep Series I, 4.78% (b)(d) 8,291,146
11,247,500 Merrill Lynch Liquidity Series, LLC Money Market Series, 5.22% (b)(c)(d) 11,247,500
Total Short-Term Securities (Cost--$19,538,646)--8.3% 19,538,646
Total Investments (Cost--$253,289,891)--105.3% 247,691,099
Number of
Contracts Options Written
Call Options Written--(0.0%)
2,300 FNMA, expiring July 2006 at USD 94.468, Broker Royal Bank of Scotland Group Plc (230)
2,800 FNMA, expiring July 2006 at USD 96.875, Broker Royal Bank of Scotland Group Plc (280)
1,850 FNMA, expiring July 2006 at USD 99.14, Broker JPMorgan Chase Bank (185)
6++ Pay fixed rate of 5.56% and receive a floating rate based on 3-month LIBOR,
expiring July 2006, Broker Lehman Brothers Special Finance (f) (5,088)
7++ Pay a fixed rate of 5.577% and receive a floating rate based on 3-month LIBOR,
expiring July 2006, Broker Credit Suisse First Boston International (f) (6,890)
11++ Pay fixed rate of 5.58% and receive a floating rate based on 3-month LIBOR,
expiring July 2006, Broker Lehman Brothers Special Finance (f) (6,985)
2++ Pay a fixed rate of 5.65% and receive a floating rate based on 3-month LIBOR,
expiring July 2006, Broker Credit Suisse First Boston International (f) (4,160)
1++ Pay fixed rate of 5.722% and receive a floating rate based on 3-month LIBOR,
expiring July 2006, Broker Lehman Brothers Special Finance (f) (5,448)
300,000 U.S. Treasury Notes, expiring July 2006 at USD 99.71, Broker Lehman Brothers Special Finance (300)
70,000 U.S. Treasury Notes, expiring July 2006 at USD 99.812, Broker Lehman Brothers Special Finance (70)
180,000 U.S. Treasury Notes, expiring July 2006 at USD 99.851, Broker Lehman Brothers Special Finance (180)
150,000 U.S. Treasury Notes, expiring July 2006 at USD 100.77, Broker Greenwich Capital Markets (150)
Total Options Written (Premiums Received--$548,156)--(0.0%) (29,966)
Total Investments, Net of Options Written (Cost--$252,741,735*)--105.3% 247,661,133
Liabilities in Excess of Other Assets--(5.3%) (12,379,488)
--------------
Net Assets--100.0% $ 235,281,645
==============
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Schedule of Investments (concluded) (in U.S. dollars)
* The cost and unrealized appreciation (depreciation) of investments,
net of options written, as of June 30, 2006, as computed for federal
income tax purposes, were as follows:
Aggregate cost $ 252,741,735
===============
Gross unrealized appreciation $ 544,129
Gross unrealized depreciation (5,624,731)
---------------
Net unrealized depreciation $ (5,080,602)
===============
** Mortgage-Backed Securities are subject to principal paydowns as a
result of prepayments or refinancing of the underlying mortgage
instruments. As a result, the average life may be substantially less
than the original maturity.
++ One contract represents a notional amount of $1,000,000.
(a) Floating rate security.
(b) Investments in companies considered to be an affiliate of the Fund,
for purposes of Section 2(a)(3) of the Investment Company Act of
1940, were as follows:
Net Interest
Affiliate Activity Income
Merrill Lynch Liquidity Series, LLC
Cash Sweep Series I $ 6,370,896 $138,273
Merrill Lynch Liquidity Series, LLC
Money Market Series $(25,136,250) $ 7,737
(c) Security was purchased with the cash proceeds from securities loans.
(d) Represents the current yield as of 6/30/2006.
(e) Security, or a portion of security, is on loan.
(f) This European style swaption, which can be exercised only on the
expiration date, represents a standby commitment whereby the writer
of the option is obligated to enter into a predetermined interest rate
swap contract upon exercise of swaption.
(g) Represents the interest-only portion of a mortgage-backed security.
o Financial futures contracts sold as of June 30, 2006 were as follows:
Number of Expiration Face Unrealized
Contracts Issue Date Value Depreciation
15 10-Year U.S. September
Treasury Note 2006 $1,564,416 $ (8,475)
See Notes to Financial Statements.
Portfolio Information as of June 30, 2006
Percent of
Total
Asset Mix Investments
Government Agency Mortgage-Backed
Securities 55.7%
Government & Agency Obligations 23.9
Non-Government Agency
Mortgage-Backed Securities 12.5
Other* 7.9
* Includes portfolio holdings in options written and short-term
investments.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Statement of Assets, Liabilities and Capital
As of June 30, 2006
Assets
Investments in unaffiliated securities, at value (including securities loaned
of $10,824,220) (identified cost--$233,751,245) $ 228,152,453
Investments in affiliated securities, at value (identified cost--$19,538,646) 19,538,646
Cash on deposit for financial futures contracts 9,750
Receivables:
Interest $ 1,623,082
Securities lending 903
Principal paydowns 575 1,624,560
---------------
Other assets 31,574
---------------
Total assets 249,356,983
---------------
Liabilities
Collateral on securities loaned, at value 11,247,500
Options written, at value (premiums received--$548,156) 29,966
Bank overdraft 198,388
Payables:
Securities purchased 2,036,469
Dividends to shareholders 392,804
Investment adviser 153,814
Variation margin 6,797
Other affiliates 2,502 2,592,386
---------------
Accrued expenses 7,098
---------------
Total liabilities 14,075,338
---------------
Net Assets
Net assets $ 235,281,645
===============
Capital
Common Stock, par value $.10 per share; 200,000,000 shares authorized $ 1,270,524
Paid-in capital in excess of par 241,051,490
Accumulated distributions in excess of investment income--net $ (3,570,352)
Undistributed realized capital gains--net 1,619,060
Unrealized depreciation--net (5,089,077)
---------------
Total accumulated losses--net (7,040,369)
---------------
Total capital--Equivalent to $18.52 per share based on 12,705,236 shares of
capital stock outstanding (market value--$17.75) $ 235,281,645
===============
See Notes to Financial Statements.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Statement of Operations
For the Six Months Ended June 30, 2006
Investment Income
Interest (including $138,273 from affiliates) $ 6,137,931
Securities lending--net 7,737
---------------
Total income 6,145,668
---------------
Expenses
Investment advisory fees $ 1,008,310
Accounting services 41,486
Professional fees 24,275
Printing and shareholder reports 21,015
Transfer agent fees 20,775
Directors' fees and expenses 10,563
Listing fees 8,581
Custodian fees 5,689
Pricing services 1,662
Other 25,760
---------------
Total expenses 1,168,116
---------------
Investment income--net 4,977,552
---------------
Realized & Unrealized Gain (Loss)--Net
Realized gain (loss) on:
Investments--net (705,762)
Futures contracts--net 105,402
Short sales--net 2,782
Options written--net 2,294,841 1,697,263
---------------
Change in unrealized appreciation/depreciation on:
Investments--net (6,814,589)
Futures contracts--net (8,475)
Options written--net 633,930 (6,189,134)
--------------- ---------------
Total realized and unrealized loss--net (4,491,871)
---------------
Net Increase in Net Assets Resulting from Operations $ 485,681
===============
See Notes to Financial Statements.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Statements of Changes in Net Assets
For the Six For the Period
Months Ended October 31, 2005++
June 30, to December 31,
Increase (Decrease) in Net Assets: 2006 2005
Operations
Investment income--net $ 4,977,552 $ 1,636,810
Realized gain--net 1,697,263 113,056
Change in unrealized appreciation/depreciation--net (6,189,134) 1,100,057
--------------- ---------------
Net increase in net assets resulting from operations 485,681 2,849,923
--------------- ---------------
Dividends & Distributions to Shareholders
Investment income--net (8,893,691) (1,291,023)
Realized gain--net -- (191,259)
--------------- ---------------
Net decrease in net assets resulting from dividends and distributions to shareholders (8,893,691) (1,482,282)
--------------- ---------------
Capital Stock Transactions
Net proceeds from issuance of Common Stock -- 242,570,000
Offering costs resulting from the issuance of Common Stock -- (347,994)
--------------- ---------------
Net increase in net assets resulting from capital stock transactions -- 242,222,006
--------------- ---------------
Net Assets
Total increase (decrease) in net assets (8,408,010) 243,589,647
Beginning of period 243,689,655 100,008
--------------- ---------------
End of period* $ 235,281,645 $ 243,689,655
=============== ===============
* Undistributed (accumulated distributions in excess of) investment income--net $ (3,570,352) $ 345,787
=============== ===============
++ Commencement of operations.
See Notes to Financial Statements.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Financial Highlights
For the Six For the Period
Months Ended October 31, 2005++
The following per share data and ratios have been derived June 30, to December 31,
from information provided in the financial statements. 2006 2005
Per Share Operating Performance
Net asset value, beginning of period $ 19.18 $ 19.10
--------------- ---------------
Investment income--net** .39 .13
Realized and unrealized gain (loss)--net (.35) .10
--------------- ---------------
Total from investment operations .04 .23
--------------- ---------------
Less dividends and distributions:
Investment income--net (.70) (.10)
Realized gain--net -- (.02)
--------------- ---------------
Total dividends and distributions (.70) (.12)
--------------- ---------------
Offering costs resulting from the issuance of Common Stock -- (.03)
--------------- ---------------
Net asset value, end of period $ 18.52 $ 19.18
=============== ===============
Market price per share, end of period $ 17.75 $ 18.09
=============== ===============
Total Investment Return++++
Based on net asset value per share .33%+++ 1.06%+++
=============== ===============
Based on market price per share 1.96%+++ (8.97%)+++
=============== ===============
Ratios to Average Net Assets
Expenses .98%* .94%*
=============== ===============
Investment income--net 4.20%* 3.89%*
=============== ===============
Supplemental Data
Net assets, end of period (in thousands) $ 235,282 $ 243,690
=============== ===============
Portfolio turnover 42.48% 20.10%
=============== ===============
* Annualized.
** Based on average shares outstanding.
++ Commencement of operations.
++++ Total investment returns based on market price, which can be significantly greater or lesser than
the net asset value, may result in substantially different returns. Total investment returns exclude
the effects of sales charges.
+++ Aggregate total investment return.
See Notes to Financial Statements.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Notes to Financial Statements
1. Significant Accounting Policies:
Enhanced Government Fund, Inc. (the "Fund") is registered under the Investment
Company Act of 1940, as amended, as a diversified, closed-end management
investment company. The Fund's financial statements are prepared in conformity
with U.S generally accepted accounting principles, which may require the use
of management accruals and estimates. Actual results may differ from these
estimates. These unaudited financial statements reflect all adjustments, which
are, in the opinion of management, necessary to present a fair statement of
the results for the interim period. All such adjustments are of a normal,
recurring nature. The Fund determines and makes available for publication the
net asset value of its Common Stock on a daily basis. The Fund's Common Stock
shares are listed on the New York Stock Exchange ("NYSE") under the symbol
EGF. The following is a summary of significant accounting policies followed by
the Fund.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Notes to Financial Statements (continued)
(a) Valuation of investments--Debt securities are traded primarily in the over-
the-counter ("OTC") markets and are valued at the last available bid price in
the OTC market or on the basis of values obtained by a pricing service.
Pricing services use valuation matrixes that incorporate both dealer-supplied
valuations and valuation models. The procedures of the pricing service and its
valuations are reviewed by the officers of the Fund under the general
direction of the Board of Directors. Such valuations and procedures will be
reviewed periodically by the Board of Directors of the Fund. Financial futures
contracts and options thereon, which are traded on exchanges, are valued at
their closing prices as of the close of such exchanges. Options written or
purchased are valued at the last sale price in the case of exchange-traded
options. In the case of options traded in the OTC market, valuation is the
last asked price (options written) or the last bid price (options purchased).
Swap agreements are valued based upon quoted fair valuations received daily by
the Fund from a pricing service or counterparty. Short-term investments with a
remaining maturity of 60 days or less are valued at amortized cost, which
approximates market value, under which method the investment is valued at cost
and any premium or discount is amortized on a straight line basis to maturity.
Repurchase agreements are valued at cost plus accrued interest. Investments in
open-end investment companies are valued at their net asset value each
business day. Valuation of other short-term investment vehicles is generally
based on the net asset value of the underlying investment vehicle or amortized
cost. Securities and other assets for which market quotations are not readily
available are valued at fair value as determined in good faith by or under the
direction of the Board of Directors of the Fund.
Equity securities that are held by the Fund, which are traded on stock
exchanges or the Nasdaq National Market, are valued at the last sale price or
official close price on the exchange, as of the close of business on the day
the securities are being valued or, lacking any sales, at the last available
bid price for long positions, and at the last available asked price for short
positions. In cases where equity securities are traded on more than one
exchange, the securities are valued on the exchange designated as the primary
market by or under the authority of the Board of Directors of the Fund. Long
positions traded in the OTC market, Nasdaq Small Cap or Bulletin Board are
valued at the last available bid price obtained from one or more dealers or
pricing services approved by the Board of Directors of the Fund. Short
positions traded in the OTC market are valued at the last available asked
price. Portfolio securities that are traded both in the OTC market and on a
stock exchange are valued according to the broadest and most representative
market.
Generally, trading in foreign securities, as well as U.S. government
securities, money market instruments and certain fixed income securities is
substantially completed each day at various times prior to the close of
business on the NYSE. The values of such securities used in computing the net
asset value of the Fund's shares are determined as of such times. Foreign
currency exchange rates also are generally determined prior to the close of
business on the NYSE. Occasionally, events affecting the values of such
securities and such exchange rates may occur between the times at which they
are determined and the close of business on the NYSE that may not be reflected
in the computation of the Fund's net asset value. If events (for example, a
company announcement, market volatility or a natural disaster) occur during
such periods that are expected to materially affect the value of such
securities, those securities may be valued at their fair value as determined
in good faith by the Fund's Board of Directors or by the Investment Adviser
using a pricing service and/or procedures approved by the Fund's Board of
Directors.
(b) Derivative financial instruments--The Fund may engage in various portfolio
investment strategies both to increase the return of the Fund and to hedge,
or protect, its exposure to interest rate movements and movements in the
securities markets. Losses may arise due to changes in the value of the
contract or if the counterparty does not perform under the contract.
* Options--The Fund may write and purchase call and put options. When the Fund
writes an option, an amount equal to the premium received by the Fund is
reflected as an asset and an equivalent liability. The amount of the liability
is subsequently marked-to-market to reflect the current market value of the
option written. When a security is purchased or sold through an exercise of an
option, the related premium paid (or received) is added to (or deducted from)
the basis of the security acquired or deducted from (or added to) the proceeds
of the security sold. When an option expires (or the Fund enters into a
closing transaction), the Fund realizes a gain or loss on the option to the
extent of the premiums received or paid (or gain or loss to the extent the
cost of the closing transaction exceeds the premium paid or received).
Written and purchased options are non-income producing investments.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Notes to Financial Statements (continued)
* Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts. Futures contracts are
contracts for delayed delivery of securities at a specific future date and at
a specific price or yield. Upon entering into a contract, the Fund deposits
and maintains as collateral such initial margin as required by the exchange on
which the transaction is effected. Pursuant to the contract, the Fund agrees
to receive from or pay to the broker an amount of cash equal to the daily
fluctuation in value of the contract. Such receipts or payments are known as
variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
* Swaps--The Fund may enter into swap agreements, which are OTC contracts in
which the Fund and a counterparty agree to make periodic net payments on a
specified notional amount. The net payments can be made for a set period of
time or may be triggered by a predetermined credit event. The net periodic
payments may be based on a fixed or variable interest rate; the change in
market value of a specified security, basket of securities, or index; or the
return generated by a security. These periodic payments received or made by
the Fund are recorded in the accompanying Statement of Operations as realized
gains or losses, respectively. Gains or losses are realized upon termination
of the swap agreements. Swaps are marked-to-market daily and changes in value
are recorded as unrealized appreciation (depreciation). Risks include changes
in the returns of the underlying instruments, failure of the counterparties to
perform under the contracts' terms and the possible lack of liquidity with
respect to the swap agreements.
(c) Income taxes--It is the Fund's policy to comply with the requirements of
the Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no federal income tax provision is required.
(d) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Realized gains and losses on security transactions are determined on the
identified cost basis. Dividend income is recorded on the ex-dividend dates.
Interest income is recognized on the accrual basis. The Fund amortizes all
premiums and discounts on debt securities.
(e) Dividends and distributions--Dividends from net investment income are
declared and paid monthly. Distributions of capital gains are recorded on the
ex-dividend dates.
(f) Offering expenses--Direct expenses relating to the public offering of the
Fund's Common Stock were charged to capital at the time of issuance of the
shares.
(g) Securities lending--The Fund may lend securities to financial institutions
that provide cash or securities issued or guaranteed by the U.S. government as
collateral, which will be maintained at all times in an amount equal to at
least 100% of the current market value of the loaned securities. The market
value of the loaned securities is determined at the close of business of the
Fund and any additional required collateral is delivered to the Fund on the
next business day. Where the Fund receives securities as collateral for the
loaned securities, it collects a fee from the borrower. The Fund typically
receives the income on the loaned securities but does not receive the income
on the collateral. Where the Fund receives cash collateral, it may invest such
collateral and retain the amount earned on such investment, net of any amount
rebated to the borrower. Loans of securities are terminable at any time and
the borrower, after notice, is required to return borrowed securities within
five business days. The Fund may pay reasonable finder's, lending agent,
administrative and custodial fees in connection with its loans. In the event
that the borrower defaults on its obligation to return borrowed securities
because of insolvency or for any other reason, the Fund could experience
delays and costs in gaining access to the collateral. The Fund also could
suffer a loss where the value of the collateral falls below the market value
of the borrowed securities, in the event of borrower default or in the event
of losses on investments made with cash collateral.
(h) Short sales--When the Fund engages in a short sale, an amount equal to the
proceeds received by the Fund is reflected as an asset and an equivalent
liability. The amount of the liability is subsequently marked-to-market to
reflect the market value of the short sale. The Fund maintains a segregated
account of securities as collateral for the short sales. The Fund is exposed
to market risk based on the amount, if any, that the market value of the stock
exceeds the market value of the securities in the segregated account. The Fund
is required to repay the counterparty any dividends or interest received on
the security sold short.
(i) Bank overdraft--The Fund recorded a bank overdraft, resulting from a
timing difference of security transaction settlements.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Notes to Financial Statements (concluded)
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with Fund Asset
Management, L.P. ("FAM"). The general partner of FAM is Princeton Services,
Inc. ("PSI"), an indirect, wholly-owned subsidiary of Merrill Lynch & Co.,
Inc. ("ML & Co."), which is the limited partner.
FAM is responsible for the management of the Fund's portfolio and provides the
necessary personnel, facilities, equipment and certain other services
necessary to the operations of the Fund. For such services the Fund pays a
monthly fee at an annual rate of .85% of the Fund's average daily net assets.
The Fund has received an exemptive order from the Securities and Exchange
Commission permitting it to lend portfolio securities to Merrill Lynch,
Pierce, Fenner & Smith Incorporated ("MLPF&S"), an affiliate of FAM, or its
affiliates. Pursuant to that order, the Fund also has retained Merrill Lynch
Investment Managers, LLC ("MLIM, LLC"), an affiliate of FAM, as the securities
lending agent for a fee based on a share of the returns on investment of cash
collateral. MLIM, LLC may, on behalf of the Fund, invest cash collateral
received by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money market funds
advised by Merrill Lynch Investment Managers, L.P. ("MLIM"), an affiliate of
FAM. For the six months ended June 30, 2006, MLIM, LLC received $2,805 in
securities lending agent fees.
For the six months ended June 30, 2006, the Fund reimbursed FAM $2,461 for
certain accounting services.
Certain officers and/or directors of the Fund are officers and/or directors of
FAM, PSI, ML & Co., MLIM, and/or MLIM, LLC.
In February 2006, ML & Co. and BlackRock, Inc. entered into an agreement to
contribute ML & Co.'s investment management business, including FAM, to the
investment management business of BlackRock, Inc. The transaction is expected
to close at the end of the third quarter of 2006.
3. Investments:
Purchases and sales (including paydowns) of investments, excluding short-term
securities, for the six months ended June 30, 2006 were $100,151,597 and
$105,495,252, respectively.
Transactions in options written for the six months ended June 30, 2006 were as
follows:
Number of Premiums
Contracts++ Received
Outstanding call options written,
beginning of period 9,350 $ 688,822
Options written 3,535,957 3,460,050
Options expired (2,672,105) (2,695,369)
Options closed (166,225) (905,347)
-------------- ---------------
Outstanding call options written,
end of period 706,977 $ 548,156
============== ===============
++ Some contracts include a notional amount of $1,000,000.
4. Capital Share Transactions:
The Fund is authorized to issue 200,000,000 shares of capital stock, par value
$.10, all of which were initially classified as Common Stock. The Board of
Directors is authorized, however, to classify and reclassify any unissued
shares of capital stock without approval of the holders of Common Stock.
Shares issued and outstanding during the six months ended June 30, 2006
remained constant and during the period October 31, 2005 to December 31, 2005
increased by 12,700,000 from shares sold.
5. Subsequent Event:
The Fund paid an ordinary income dividend in the amount of $.116667 per share
on July 31, 2006 to shareholders on record on July 21, 2006.
6. Change in Independent Registered Public Accounting Firm:
Effective August 28, 2006, Ernst & Young LLP ("E&Y") resigned as Independent
Registered Public Accounting Firm of the Fund.
E&Y's report on the financial statements of the Fund for the past five fiscal
years did not contain an adverse opinion or a disclaimer of opinion and were
not qualified or modified as to uncertainty, audit scope or accounting
principles.
In connection with its audits for the two most recent fiscal years and through
June 30, 2006 (1) there were no disagreements with E&Y on any matter of
accounting principle or practices, financial statement disclosure or auditing
scope or procedure, whereby such disagreements, if not resolved to the
satisfaction of E&Y, would have caused them to make reference to the subject
matter of the disagreements in connection with their report on the financial
statements for such years; and (2) there have been no reportable events (as
defined in Item 304(a)(1)(v) of Regulation S-K).
The Fund engaged Deloitte & Touche LLP as the Fund's Independent Registered
Public Accounting Firm for the fiscal year ending December 31, 2006.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Disclosure of Investment Advisory Agreement
Activities and Composition of the Board of Directors
All but one member of the Board of Directors of the Fund is an independent
director whose only affiliation with Fund Asset Management, L.P. (the
"Investment Adviser") or other Merrill Lynch affiliates is as a director of
the Fund and as a trustee or director of certain other funds advised by the
Investment Adviser or its affiliates. The Chair of the Board is an independent
director. New director nominees are chosen by a Nominating Committee comprised
entirely of independent directors. All independent directors also are members
of the Board's Audit Committee, and the independent directors meet in
executive session at each in-person Board meeting. The Board and the Audit
Committee meet in person for at least two days each quarter and conduct other
in-person and telephone meetings throughout the year, some of which are formal
Board meetings and some of which are informational meetings. Independent
counsel to the independent directors attends all in-person Board and Audit
Committee meetings and other meetings at the independent directors' request.
Investment Advisory Agreements--Matters Considered by the Board
Every year, the Board considers approval of the Fund's investment advisory
agreement (the "Investment Advisory Agreement"). The Board assesses the
nature, scope and quality of the services provided to the Fund by the
personnel of the Investment Adviser and its affiliates, including
administrative services, shareholder services, oversight of fund accounting,
marketing services and assistance in meeting legal and regulatory
requirements. The Board also receives and assesses information regarding the
services provided to the Fund by certain unaffiliated service providers.
At various times throughout the year, the Board also considers a range of
information in connection with its oversight of the services provided by the
Investment Adviser and its affiliates. Among the matters considered are: (a)
fees (in addition to management fees) paid to the Investment Adviser and its
affiliates by the Fund; (b) Fund operating expenses paid to third parties;
(c) the resources devoted to and compliance reports relating to the Fund's
investment objective, policies and restrictions, and the Fund's compliance
with its Code of Ethics and the Investment Adviser's compliance policies and
procedures; and (d) the nature, cost and character of non-investment
management services provided by the Investment Adviser and its affiliates.
The Board believes that the Investment Adviser is one of the most experienced
global asset management firms and considers the overall services provided by
the Investment Adviser to be of high quality. The Board also believes that the
Investment Adviser is financially sound and well managed and notes that the
Investment Adviser is affiliated with one of America's largest financial
firms. The Board works closely with the Investment Adviser in overseeing the
Investment Adviser's efforts to achieve good performance. As part of this
effort, the Board discusses portfolio manager effectiveness and, when
performance is not satisfactory, discusses with the Investment Adviser taking
steps such as changing investment personnel.
Annual Consideration of Approval by the Board of Directors
In the period prior to the Board meeting to consider renewal of the Investment
Advisory Agreement, the Board requests and receives materials specifically
relating to the Investment Advisory Agreement. These materials include (a)
information compiled by Lipper Inc. ("Lipper") on the fees and expenses of the
Fund as compared to a comparable group of funds as classified by Lipper; (b)
information concerning the Fund's performance; (c) a discussion by the Fund's
portfolio management team of investment strategies used by the Fund during its
most recent fiscal year; (d) information on the profitability to the
Investment Adviser and its affiliates of the Investment Advisory Agreements
and other relationships with the Fund; and (e) information provided by the
Investment Adviser concerning investment advisory fees charged to other funds
under a similar investment mandate. The Board also considers other matters it
deems important to the approval process, such as payments made to the
Investment Adviser or its affiliates in connection with services related to
the valuation and pricing of Fund portfolio holdings, the Fund's portfolio
turnover statistics, and direct and indirect benefits to the Investment
Adviser and its affiliates from their relationship with the Fund. The Board
did not identify any particular information as controlling, and each member of
the Board attributed different weights to the various items considered.
Certain Specific Renewal Data
In connection with the most recent renewal of the Fund's Investment Advisory
Agreement in May 2006, the independent directors' and the Board's review
included the following:
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Services Provided by the Investment Adviser--The Board reviewed the nature,
extent and quality of services provided by the Investment Adviser, including
the investment advisory services and the resulting performance of the Fund.
The Board focused primarily on the Investment Adviser's investment advisory
services and the Fund's investment performance. The Board compared Fund
performance to the performance of a relevant index or combination of indexes.
The Board noted, however, that the closed-end nonleveraged general U.S.
government funds included in the Lipper information were not truly comparable
since these funds do not utilize the Fund's strategy of writing call options.
While the Board reviews performance data at least quarterly, consistent with
the Investment Adviser's investment goals, the Board attaches more importance
to performance over relatively long periods of time, typically three to five
years, or a shorter period in the case of a fund that has been in existence
less than five years. The Board noted that the Fund only recently commenced
operations (on October 31, 2005). The Board concluded that the nature and
quality of the services and the Fund's performance thus far supported the
continuation of the Investment Advisory Agreement.
The Investment Adviser's Personnel and Investment Process--The Board reviews
at least annually the Fund's investment objectives and strategies. The Board
discusses with senior management of the Investment Adviser responsible for
investment operations and the senior management of the Investment Adviser's
taxable fixed income investing group the strategies being used to achieve the
stated objectives. Among other things, the Board considers the size, education
and experience of the Investment Adviser's investment staff, its use of
technology, and the Investment Adviser's approach to training and retaining
portfolio managers and other research, advisory and management personnel. The
Board also reviews the Investment Adviser's compensation policies and
practices with respect to the Fund's portfolio managers. The Board also
considered the experience of the Fund's portfolio managers and noted that each
of Messrs. Frank Viola and Thomas Musmanno, the Fund's portfolio managers,
have over 10 years' experience investing in fixed income securities and in
selecting and managing derivative investments. Moreover, the Investment
Adviser and its investment staff have extensive experience in analyzing and
managing the types of investments used by the Fund. The Board concluded that
the Fund benefits from that expertise.
Management Fees and Other Expenses--The Board reviews the Fund's contractual
management fee rate as a percentage of total assets at common asset levels -
the actual rate includes advisory and administrative service fees and the
effects of any fee waivers - compared to the other funds considered comparable
by Lipper. It also compares the Fund's total expenses to those of other
comparable funds. However, the Board noted that no truly comparable funds were
included in the Lipper information and that the Investment Adviser had advised
the Board that it had no other comparable accounts with similar investment
mandates. The Board also noted that as a result of the Fund's strategy of
writing call options, management of the Fund's portfolio is more complex than
management of a more traditional portfolio of fixed income securities. The
Board concluded that the Fund's management fee rate and over-all expense ratio
are reasonable.
Profitability--The Board considers the cost of the services provided to
the Fund by the Investment Adviser and the Investment Adviser's and its
affiliates' profits relating to the management and distribution of the Fund
and the MLIM/FAM-advised funds. As part of its analysis, the Board reviewed
the Investment Adviser's methodology in allocating its costs to the management
of the Fund and concluded that there was a reasonable basis for the
allocation. The Board concluded that the profits of the Investment Adviser and
its affiliates are reasonable in relation to the nature and quality of
services provided and given the level of fees and expenses overall.
Economies of Scale--The Board considered the extent to which economies of
scale might be realized as the assets of the Fund increase and whether there
should be changes in the management fee rate or structure in order to enable
the Fund to participate in these economies of scale. Because the Fund is a
closed-end fund, the Board concluded that the assets of the Fund are unlikely
to increase significantly and that the current advisory fee appropriately
reflects any economies of scale. The Board determined that the management fee
structure was reasonable and that no changes were currently necessary.
Conclusion
After the independent directors deliberated in executive session, the entire
Board of the Fund, including all of the independent directors, approved the
renewal of the existing Investment Advisory Agreement, concluding that the
advisory fee was reasonable in relation to the services provided and that a
contract renewal was in the best interests of the shareholders.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Disclosure of New Investment Advisory Agreement
New BlackRock Investment Advisory Agreement--Matters Considered by the Board
In connection with the Transaction between Merrill Lynch and BlackRock, the
Fund's Board of Directors considered a new investment advisory agreement (the
"New Investment Advisory Agreement") between the Fund and BlackRock Advisors,
Inc. or its successor ("BlackRock Advisors"). If the New Investment Advisory
Agreement is approved by the Fund's shareholders, it will become effective
upon the closing of the Transaction, which is expected in the third quarter of
2006.
The Board discussed the New Investment Advisory Agreement at telephonic and
in-person meetings held during April and May 2006. The Board, including the
independent directors, approved the New Investment Advisory Agreement at a
meeting held on May 10, 2006.
To assist the Board in its consideration of the New Investment Advisory
Agreement, BlackRock provided materials and information about BlackRock,
including its financial condition and asset management capabilities and
organization, and Merrill Lynch provided materials and information about the
Transaction. The independent directors, through their independent legal
counsel, also requested and received additional information from Merrill Lynch
and BlackRock in connection with their consideration of the New Investment
Advisory Agreement. The additional information was provided in advance of the
May 10, 2006 meeting. In addition, the independent directors consulted with
their counsel and Fund counsel on numerous occasions, discussing, among other
things, the legal standards and certain other considerations relevant to the
directors' deliberations.
At the Board meetings, the directors discussed with Merrill Lynch management
and certain BlackRock representatives the Transaction, its strategic rationale
and BlackRock's general plans and intentions regarding the Fund. At these
Board meetings, representatives of Merrill Lynch and BlackRock made
presentations to and responded to questions from the Board. The directors also
inquired about the plans for and anticipated roles and responsibilities of
certain employees and officers of the Investment Adviser and certain
affiliates being transferred to BlackRock in connection with the Transaction.
The independent directors also conferred separately and with their counsel
about the Transaction and other matters related to the Transaction on a number
of occasions, including in connection with the April and May 2006 meetings.
After the presentations and after reviewing the written materials provided,
the independent directors met in executive sessions with their counsel to
consider the New Investment Advisory Agreement.
In connection with the Board's review of the New Investment Advisory
Agreement, Merrill Lynch and/or BlackRock advised the directors about a
variety of matters. The advice included the following, among other matters:
* that there is not expected to be any diminution in the nature, quality and
extent of services provided to the Fund and its shareholders by BlackRock
Advisors, including compliance services;
* that operation of New BlackRock as an independent investment management
firm will enhance its ability to attract and retain talented professionals;
* that the Fund should benefit from having access to BlackRock's state of the
art technology and risk management analytic tools, including investment
tools, provided under the BlackRock Solutions (R) brand name;
* that BlackRock has no present intention to alter any applicable expense
waivers or reimbursements currently in effect and, while it reserves the
right to do so in the future, it would seek the approval of the Board
before making any changes;
* that in connection with the Transaction, Merrill Lynch and BlackRock have
agreed to conduct, and use reasonable best efforts to cause their
respective affiliates to conduct, their respective businesses in compliance
with the conditions of Section 15(f) of the Investment Company Act of 1940
(the "1940 Act") in relation to any public funds advised by BlackRock or
the Investment Adviser (or its affiliates), respectively; and
* that Merrill Lynch and BlackRock would derive benefits from the Transaction
and that, as a result, they have a different financial interest in the
matters that were being considered than do Fund shareholders.
The directors considered the information provided by Merrill Lynch and
BlackRock above, and, among other factors, the following:
* the potential benefits to Fund shareholders from being part of a combined
fund family with BlackRock-sponsored funds, including possible economies of
scale and access to investment opportunities;
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
* the reputation, financial strength and resources of BlackRock and its
investment advisory subsidiaries and the anticipated financial strength and
resources of New BlackRock;
* the compliance policies and procedures of BlackRock Advisors;
* the terms and conditions of the New Investment Advisory Agreement,
including the fact that the schedule of the Fund's total advisory fees will
not increase by virtue of the New Investment Advisory Agreement, but will
remain the same;
* that the Board had earlier performed an initial review of the investment
advisory agreement currently in effect for the Fund (the "Current
Investment Advisory Agreement") as required by the 1940 Act and determined
that the Investment Adviser has the capabilities, resources and personnel
necessary to provide the advisory and administrative services currently
provided to the Fund; and that the advisory and/or management fees to be
paid by the Fund, taking into account any applicable agreed-upon fee
waivers and breakpoints, represented reasonable compensation to the
Investment Adviser in light of the services to be provided, the expected
costs to the Investment Adviser of providing those services, potential
economies of scale, the fees and other expenses paid by similar funds
(including information provided by Lipper Inc. ["Lipper"]), and such other
matters as the directors considered relevant in the exercise of their
reasonable judgment; and
* that Merrill Lynch agreed to pay all expenses of the Fund in connection
with the Board's consideration of the New Investment Advisory Agreement and
related agreements and all costs of shareholder approval of the New
Investment Advisory Agreement and as a result the Fund would bear no costs
in obtaining shareholder approval of the New Investment Advisory Agreement.
Certain of these considerations are discussed in more detail below.
In its review of the New Investment Advisory Agreement, the Board assessed the
nature, scope and quality of the services to be provided to the Fund by the
personnel of BlackRock Advisors and its affiliates, including administrative
services, shareholder services, oversight of fund accounting and assistance in
meeting legal and regulatory requirements. In its review of the New Investment
Advisory Agreement, the Board also considered a range of information in
connection with its oversight of the services to be provided by BlackRock
Advisors and its affiliates. Among the matters considered were: (a) fees (in
addition to management fees) to be paid to BlackRock Advisors and its
affiliates by the Fund; (b) Fund operating expenses paid to third parties; (c)
the resources devoted to and compliance reports relating to the Fund's
investment objective, policies and restrictions, and its compliance with its
Code of Ethics and BlackRock Advisors' compliance policies and procedures; and
(d) the nature, cost and character of non-investment management services to be
provided by BlackRock Advisors and its affiliates.
In the period prior to the Board meeting to consider the initial approval of
the Current Investment Advisory Agreement, the Board had requested and
received materials specifically relating to the Current Investment Advisory
Agreement. These materials included (a) information compiled by Lipper on the
expected fees and expenses of the Fund as compared to a comparable group of
funds as classified by Lipper; (b) information on the Fund's portfolio
management team and investment strategies to be used by the Fund; and (c)
information on the payments expected to be received by the Investment Adviser
and its affiliates from the Fund.
In their deliberations, the directors considered information received in
connection with their initial consideration of the Current Investment Advisory
Agreement, in addition to information provided by BlackRock and BlackRock
Advisors in connection with their evaluation of the terms and conditions of
the New Investment Advisory Agreement. The directors did not identify any
particular information that was all-important or controlling, and each
director attributed different weights to the various factors. The directors,
including a majority of the independent directors, concluded that the terms of
the New Investment Advisory Agreement are appropriate, that the fees to be
paid are reasonable in light of the services to be provided to the Fund, and
that the New Investment Advisory Agreement should be approved and recommended
to Fund shareholders.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Disclosure of New Investment Advisory Agreement (continued)
Nature, Quality and Extent of Services Provided--The Board reviewed the
nature, extent and quality of services provided by the Investment Adviser,
including the investment advisory services and the resulting performance of
the Fund, as well as the nature, quality and extent of services expected to be
provided by BlackRock Advisors. The Board focused primarily on the Investment
Adviser's advisory services and the Fund's investment performance, but also
considered certain areas in which both the Investment Adviser and the Fund
receive services as part of the Merrill Lynch complex. The Board compared the
Fund's performance - both including and excluding the effects of the Fund's
fees and expenses - to the performance of a comparable group of funds, and the
performance of a relevant index or combination of indexes. While the Board
reviews performance data at least quarterly, consistent with the Investment
Adviser's investment goals, the Board will attach more importance to
performance over relatively long periods of time, typically three to five
years.
In evaluating the nature, quality and extent of the services to be provided by
BlackRock Advisors under the New Investment Advisory Agreement, the directors
considered, among other things, the expected impact of the Transaction on the
operations, facilities, organization and personnel of BlackRock Advisors and
how it would affect the Fund; the ability of BlackRock Advisors to perform its
duties after the Transaction; and any anticipated changes to the current
investment and other practices of the Fund. The directors considered
BlackRock's advice as to proposed changes in portfolio management personnel of
the Fund after the closing of the Transaction.
The directors were given information with respect to the potential benefits to
the Fund and its shareholders from having access to BlackRock's state of the
art technology and risk management analytic tools, including the investment
tools provided under the BlackRock Solutions brand name.
The directors were advised that, as a result of Merrill Lynch's equity
interest in BlackRock after the Transaction, the Fund will continue to be
subject to restrictions concerning certain transactions involving Merrill
Lynch affiliates (for example, transactions with a Merrill Lynch broker-dealer
acting as principal) absent revised or new regulatory relief. The directors
were advised that a revision of existing regulatory relief with respect to
these restrictions was being sought from the Securities and Exchange
Commission and were advised of the possibility of receipt of such revised
regulatory relief. There can be no assurance that such relief will be
obtained.
Based on their review of the materials provided and the assurances they had
received from the management of Merrill Lynch and of BlackRock, the directors
determined that the nature and quality of services to be provided to the Fund
under the New Investment Advisory Agreement were expected to be as good as or
better than that provided under the Current Investment Advisory Agreement. It
was noted, however, that it is expected that there will be changes in
personnel following the Transaction and the combination of the operations of
the Investment Adviser and its affiliates with those of BlackRock. The
directors noted that if current portfolio managers or other personnel cease to
be available, the Board would consider all available options, which could
include seeking the investment advisory or other services of BlackRock
affiliates. Accordingly, the directors concluded that, overall, they were
satisfied at the present time with assurances from BlackRock and BlackRock
Advisors as to the expected nature, extent and quality of the services to be
provided to the Fund under the New Investment Advisory Agreement.
Costs of Services Provided and Profitability--It was noted that, in
conjunction with their initial consideration of the Current Investment
Advisory Agreement, the directors had received, among other things, a report
from Lipper comparing the Fund's expected fees and expenses to those of a peer
group selected by Lipper, and information as to the fees charged by the
Investment Adviser or its affiliates to other registered investment company
clients for investment management services. The Board reviewed the Fund's
contractual management fee rate and actual management fee rate as a percentage
of total assets at common asset levels - the actual rate includes advisory
fees and the effects of any fee waivers - compared to the other funds in its
Lipper category. They also compared the Fund's total expenses to those of
other comparable funds. The information showed that the Fund had fees and
expenses within the range of fees and expenses of comparable funds. The Board
considered the services to be provided by and the fees to be charged by
BlackRock Advisors to other funds with similar investment mandates and noted
that the fees charged by BlackRock Advisors in those cases, including fee
waivers and expense reimbursements, were generally comparable to those being
charged to the Fund. The Board also noted that, as a general matter, according
to the information provided by BlackRock, fees charged to institutional
clients were lower than the fees charged to the Fund, but BlackRock Advisors
provided less extensive services to such clients. The Board concluded that the
Fund's management fee and fee rate and overall expense ratio are reasonable
compared to those of other comparable funds.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
In evaluating the costs of the services to be provided by BlackRock Advisors
under the New Investment Advisory Agreement, the directors considered, among
other things, whether advisory fees or other expenses would change as a result
of the Transaction. Based on their review of the materials provided and the
fact that the New Investment Advisory Agreement is substantially similar to
the Current Investment Advisory Agreement in all material respects, including
the rate of compensation, the directors determined that the Transaction should
not increase the total fees payable, including any fee waivers and expense
reimbursements, for advisory and administrative services. The directors noted
that it was not possible to predict with certainty New BlackRock's future
profitability from its relationship with the Fund.
The directors discussed with BlackRock Advisors its general methodology to be
used in determining New BlackRock's profitability with respect to its
relationship with the Fund. The directors noted that they expect to receive
profitability information from New BlackRock on at least an annual basis and
thus be in a position to evaluate whether any adjustments in Fund fees and/or
fee breakpoints would be appropriate.
Fees and Economies of Scale--The Board considered the extent to which
economies of scale might be realized as the assets of the Fund increase and
whether there should be changes in the management fee rate or structure in
order to enable the Fund to participate in these economies of scale. The Board
determined that changes were not currently necessary and that the Fund
appropriately participated in these economies of scale.
In reviewing the Transaction, the directors considered, among other things,
whether advisory fees or other expenses would change as a result of the
Transaction. Based on the fact that the New Investment Advisory Agreement is
substantially similar to the Current Investment Advisory Agreement in all
material respects, including the rate of compensation, the directors
determined that as a result of the Transaction, the Fund's total advisory fees
would be no higher than the fees under its Current Investment Advisory
Agreement. The directors noted that in conjunction with their initial
deliberations concerning the Current Investment Advisory Agreement, they had
determined that the expected total fees for advisory and administrative
services for the Fund were reasonable in light of the services to be provided.
It was noted that in conjunction with their initial consideration of the
Current Investment Advisory Agreement, the directors had received, among other
things, a report from Lipper comparing the Fund's expected fees and expenses
to those of a peer group selected by Lipper, and information as to the fees
charged by the Investment Adviser or its affiliates to other registered
investment company clients for investment management services. The directors
concluded that, because the rates for advisory fees for the Fund would be no
higher than its current fee rates, the proposed management fee structure,
including any fee waivers, was reasonable and that no additional changes were
currently necessary.
Fall-Out Benefits--In evaluating the fall-out benefits to be received by
BlackRock Advisors under the New Investment Advisory Agreement, the directors
considered whether the Transaction would have an impact on the fall-out
benefits received by the Investment Adviser by virtue of the Current
Investment Advisory Agreement. Based on their review of the materials
provided, including materials received in connection with their initial
approval of the Current Investment Advisory Agreement, and their discussions
with management of the Investment Adviser and BlackRock, the directors
determined that those benefits could include increased ability for BlackRock
to distribute shares of its funds and other investment products. The directors
noted that any fall-out benefits were difficult to quantify with certainty at
this time, and indicated that they would continue to evaluate them going
forward.
Investment Performance--The directors considered investment performance for
the Fund. The directors compared the Fund's performance - both including and
excluding the effects of fees and expenses - to the performance of a
comparable group of funds, and the performance of a relevant index or
combination of indexes. The comparative information received from Lipper
showed Fund performance at various levels within the range of performance of
comparable funds over different time periods. While the Board reviews
performance data at least quarterly, consistent with the Investment Adviser's
investment goals, the Board will attach more importance over relatively long
periods of time, typically three to five years. The directors believed the
Fund's performance was satisfactory. Also, the directors took into account the
investment performance of funds currently advised by BlackRock Advisors. The
Board considered comparative information from Lipper which showed that the
performance of the funds advised by BlackRock Advisors was within the range of
performance of comparable funds over different time periods. The Board noted
BlackRock's considerable investment management experience and capabilities,
but was unable to predict what effect, if any, consummation of the Transaction
would have on the future performance of the Fund.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Disclosure of New Investment Advisory Agreement (concluded)
Conclusion--After the independent directors of the Fund deliberated in
executive session, the entire Board, including the independent directors,
approved the New Investment Advisory Agreement, concluding that the advisory
fee rate was reasonable in relation to the services provided and that the New
Investment Advisory Agreement was in the best interests of the shareholders.
In approving the New Investment Advisory Agreement, the Board noted that it
anticipated reviewing the continuance of the agreement in advance of the
expiration of the initial two-year period.
Contingent BlackRock Subadvisory Agreement--Matters Considered by the Board
At the telephonic and in-person meetings held during April and May 2006 at
which the Board of Directors discussed and approved the New Investment
Advisory Agreement, the Board, including the independent directors, also
considered and approved a contingent subadvisory agreement (the "Contingent
Subadvisory Agreement") between the Investment Adviser and BlackRock Advisors
(the "BlackRock Subadviser"). The Contingent Subadvisory Agreement is intended
to ensure that the Fund operates with efficient portfolio management services
until the closing of the Transaction, in the event that the Board deems it
necessary and in the best interests of the Fund and its shareholders that the
BlackRock Subadviser assist in managing the operations of the Fund during the
interim period until the closing of the Transaction. If shareholders approve
the Contingent Subadvisory Agreement, it will take effect only upon
recommendation from the Investment Adviser and upon subsequent approval of the
Board in the period up to the closing of the Transaction. The effectiveness of
the Contingent Subadvisory Agreement, therefore, would be contingent on
further Board approval after shareholders approve it. Pursuant to the
Contingent Subadvisory Agreement, the BlackRock Subadviser would receive a
monthly fee from the Investment Adviser equal to 50% of the advisory fee
received by the Investment Adviser. The Investment Adviser would pay the
BlackRock Subadviser out of its own resources. There would be no increase in
Fund expenses as a result of the Contingent Subadvisory Agreement.
In making its approval at the May in-person meeting, the Board considered the
Contingent Subadvisory Agreement in conjunction with the New Investment
Advisory Agreement and reviewed the same information and factors discussed
above. The Board also considered in conjunction with the Contingent
Subadvisory Agreement the necessity of ensuring that the Fund operates with
effective management services until the closing of the Transaction. In
reviewing the subadvisory fee rate provided in the Contingent Subadvisory
Agreement, the Board took note of the fact that both the Investment Adviser
and the BlackRock Subadviser would have significant responsibilities under
their respective advisory agreements. The Investment Adviser would remain
responsible for oversight of the Fund's operations and administration and the
BlackRock Subadviser would provide advisory services to the Fund under the
Contingent Subadvisory Agreement. The Board also took into account the
expected short duration of the term of any Contingent Subadvisory Agreement
and the fact that total advisory fees paid by the Fund would not increase as a
result of the Contingent Subadvisory Agreement. Under all of the circumstances,
the Board concluded that it was a reasonable allocation of fees for the
BlackRock Subadviser to receive 50% of the advisory fee paid by the Fund to
the Investment Adviser.
After the independent directors deliberated in executive session, the entire
Board, including the independent directors, approved the Contingent
Subadvisory Agreement, concluding that the advisory fee was reasonable in
relation to the services provided and that the Contingent Subadvisory
Agreement was in the best interests of shareholders.
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Officers and Directors
Robert C. Doll, Jr., President and Director
David O. Beim, Director
James T. Flynn, Director
W. Carl Kester, Director
Karen P. Robards, Director
Donald C. Burke, Vice President and Treasurer
Thomas Musmanno, Vice President
Frank Viola, Vice President
Jeffrey Hiller, Chief Compliance Officer
Alice A. Pellegrino, Secretary
Custodian
State Street Bank and Trust Company
P.O. Box 351
Boston, MA 02101
Transfer Agent
The Bank of New York
101 Barclay Street--11 East
New York, NY 10286
NYSE Symbol
EGF
ENHANCED GOVERNMENT FUND, INC. JUNE 30, 2006
Item 2 - Code of Ethics - Not Applicable to this semi-annual report
Item 3 - Audit Committee Financial Expert - Not Applicable to this semi-
annual report
Item 4 - Principal Accountant Fees and Services - Not Applicable to this semi-
annual report
Item 5 - Audit Committee of Listed Registrants - Not Applicable to this semi-
annual report
Item 6 - Schedule of Investments - Not Applicable
Item 7 - Disclosure of Proxy Voting Policies and Procedures for Closed-End
Management Investment Companies - Not Applicable to this semi-annual
report
Item 8 - Portfolio Managers of Closed-End Management Investment Companies -
Not Applicable to this semi-annual report
Item 9 - Purchases of Equity Securities by Closed-End Management Investment
Company and Affiliated Purchasers - Not Applicable
Item 10 - Submission of Matters to a Vote of Security Holders - Not Applicable
Item 11 - Controls and Procedures
11(a) - The registrant's certifying officers have reasonably designed such
disclosure controls and procedures to ensure material information
relating to the registrant is made known to us by others
particularly during the period in which this report is being
prepared. The registrant's certifying officers have determined that
the registrant's disclosure controls and procedures are effective
based on our evaluation of these controls and procedures as of a
date within 90 days prior to the filing date of this report.
11(b) - There were no changes in the registrant's internal control over
financial reporting (as defined in Rule 30a-3(d) under the Act
(17 CFR 270.30a-3(d)) that occurred during the last fiscal half-
year of the period covered by this report that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting.
Item 12 - Exhibits attached hereto
12(a)(1) - Code of Ethics - Not Applicable to this semi-annual report
12(a)(2) - Certifications - Attached hereto
12(a)(3) - Not Applicable
12(b) - Certifications - Attached hereto
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, the registrant has duly caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized.
Enhanced Government Fund, Inc.
By: /s/ Robert C. Doll, Jr.
----------------------------
Robert C. Doll, Jr.,
Chief Executive Officer of
Enhanced Government Fund, Inc.
Date: August 23, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on
the dates indicated.
By: /s/ Robert C. Doll, Jr.
----------------------------
Robert C. Doll, Jr.,
Chief Executive Officer of
Enhanced Government Fund, Inc.
Date: August 23, 2006
By: /s/ Donald C. Burke
----------------------------
Donald C. Burke,
Chief Financial Officer of
Enhanced Government Fund, Inc.
Date: August 23, 2006