Fund Objective:
The Franklin Strategic Mortgage Portfolio seeks to obtain a high level of total
return relative to the performance of the general mortgage securities market.
The fund seeks to achieve this objective by investing primarily in a portfolio
of mortgage securities created from pools of mortgages which are issued or
guaranteed by the U.S. government, its agencies or instrumentalities.1
November 15, 1995
Dear Shareholder:
We are pleased to bring you the annual report for the Franklin Strategic
Mortgage Portfolio, for the fiscal year ended September 30, 1995.
Many events affected the fixed income markets during the past twelve months. The
December 1994 bankruptcy of Orange County, California, financial and political
instability in Mexico, and decisive moves by the Federal Reserve Board to fight
the threat of inflation captured the headlines for most of the reporting
period's first half. As quickly as these events appeared, however, the stock
market was reaching all-time highs and inflationary pressures retreated,
resulting in a recovery for the fixed-income market. Obviously, many changes can
occur in a short time; however, our portfolio managers maintain a long-term
perspective in managing the fund, and we encourage our shareholders to view
their investments in the same manner.
Rather than attempting to predict the direction of interest rates or making
investment decisions based purely on short-term market conditions, our managers
use traditional, time-proven strategies. In seeking to maximize the fund's total
returns, we rely on extensive research in an effort to uncover the most
attractive relative values in any given interest-rate environment. We believe
this approach best serves our shareholders.
Thank you for your continued support of the Franklin Strategic Mortgage
Portfolio. We look forward to serving your investment needs in the future.
Sincerely,
Charles B. Johnson
Chairman of the Board
1. U.S. government securities owned by the fund or held under repurchase
agreement, but not shares of the fund, are guaranteed by the U.S. government as
to timely payment of principal and interest. Yields and share price are not
guaranteed and will fluctuate with market conditions.
Overview of the Economy
During the reporting period, U.S. economic growth slowed, which lowered
inflation expectations. In the fourth quarter of 1994, Gross Domestic Product
(GDP) rose to an annualized rate of 5.1%, fueled by strong consumer spending and
high industrial production.2 Results for the first quarter of 1995, however,
were mixed. There were only moderate increases in the Consumer Price Index (CPI)
and Producer Price Index (PPI), the two primary indicators of inflation, and GDP
growth slowed to 2.7%.2 Nevertheless, high levels of manufacturing and
production by the nation's factories, as well as strength in the employment
sector persisted throughout the quarter. Continued declines in consumer spending
and demand for consumer goods produced larger-than-expected inventory levels.
Through the second and third quarters, inflation figures were flat but growth
remained sluggish. Second quarter GDP rose only 1.3%, and production levels fell
as inventories were cleared.2 With mixed signals from all areas of the economy,
including renewed strength in the employment and housing sectors, third quarter
GDP was estimated at a stronger 4.2%.2
The Federal Reserve Board played a key role in controlling growth and inflation
throughout the reporting period. Sensitive to inflationary pressures and
watchful of economic growth, the Federal Reserve repeatedly adjusted short-term
interest rates in the first half of the reporting period. Concerned that strong
production and employment would bring unwanted inflationary pressure, it raised
the federal funds rate (the interest rate banks charge each other for overnight
loans) and the discount rate (the interest rate charged for loans to member
banks) by 75 basis points each in November 1994, and another 50 basis points
each in February 1995.
2. Source: U.S. Commerce Department.
After the slow growth of the first two quarters of 1995, many feared that credit
was too restrictive and that the economy was on the verge of a recession. In
response, the Federal Reserve cut the federal funds rate by 25 basis points
during its Federal Open Market Committee meeting in July 1995 but made no
further moves during its August or September meetings. At the end of the
reporting period, the federal funds rate and discount rate stood at 5.75% and
5.25%, respectively.
Looking forward, long-term trends indicate that the fixed-income market may
continue the rally that began in the first quarter of 1995. For example, a
strong dollar should help hold down inflationary pressures through lower import
prices, and monetary rules continue to show that the Federal Reserve's target
for the federal funds rate may be "restrictive" and could be lowered in search
of a more "neutral" position. These trends appear to bode well for the bond
market.
Roger A. Bayston, CFA
Roger Bayston is portfolio manager for the Franklin Strategic Mortgage
Portfolio, Franklin Adjustable Rate Securities Fund and the Franklin Valuemark
Adjustable U.S. Government Securities Fund.
Before joining Franklin in 1991, Mr. Bayston managed portfolios of fixed-income
securities for Bankers Trust Company Investment Management Group. He holds a
Bachelor of Science degree from the University of Virginia and a Master of
Business Administration degree from the University of California at Los Angeles.
He is a member of the Security Analysts of San Francisco and the Association for
Investment Management and Research, and is a Chartered Financial Analyst.
Franklin Strategic Mortgage Portfolio
During the reporting period, we continued to diversify the portfolio into
various coupons and maturities of Government National Mortgage Association
(GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan
Mortgage Corporation (FHLMC) mortgage passthroughs. Throughout the period, we
held only the most liquid, non-derivative passthroughs, and our long-term
buy-and-hold strategy gave shareholders the opportunity to benefit from
relatively low turnover rates and transaction costs. Among the portfolio's
transactions during the year were sales of Treasury bonds and multifamily
adjustable rate mortgages, the proceeds of which were reinvested in current
coupon 15-year and 30-year passthrough securities. We also reduced our weighting
in discount mortgages. The Federal Reserve's movements to raise interest rates
in the fourth quarter of 1994 and the first quarter of 1995, and then lower
interest rates in July 1995, caused the mortgage market to underperform the
Treasury markets during these periods of high interest-rate volatility. Also,
during periods of generally declining interest rates, mortgage security
performance is constrained by the increasing risk of prepayments and the
resulting cash flow uncertainty they create. Despite these conditions, the
Franklin Strategic Mortgage Portfolio provided strong returns to shareholders
during the period. We have positioned the fund, versus the overall mortgage
market, with a slight overweighting in both lower and higher coupons in order to
mitigate the prepayment risk associated with current coupons. Going forward, we
will continue to monitor the mortgage markets, looking for the best relative
value for the fund's shareholders.
GRAPHIC MATERIAL 1 OMMITTED - SEE APPENDIX AT END OF DOCUMENT
Performance Summary
The Franklin Strategic Mortgage Portfolio paid distributions totaling 71.36
cents ($0.7136) per share for the twelve-month period ended September 30, 1995.3
The distribution rate was 7.16%, based on an annualization of the fund's
dividends over the last 30 days of the period ($0.060946 per share), and the
maximum offering price of $10.35 on September 30, 1995. Dividends will vary
based on the earnings of the fund's portfolio, and past distributions are not
necessarily indicative of future trends. The fund's share price, as measured by
net asset value, rose 49 cents ($0.49), from $9.42 on September 30, 1994 to
$9.91 on September 30, 1995.
The fund posted a total return of +13.27% for the twelve-month period ended
September 30, 1995. Total return measures the change in value of an investment,
assuming reinvestment of dividends and capital gains, if any, and does not
include the initial sales charge. Of course, past performance is not indicative
of future results. The chart on the next page illustrates the performance of the
Franklin Strategic Mortgage Portfolio against its broad-based benchmark, the
Salomon Brothers Mortgage Index.
As you can see, the fund's performance slightly lagged that of the index. Of
course, an unmanaged market index, such as the Salomon Brothers Mortgage Index,
does not pay commissions or market spreads to buy and sell bonds, nor pay fees
to cover shareholder service and custody costs. Unlike an index, investment
companies are never 100% invested because they must have cash on hand to redeem
shares. In addition, the performance shown for the fund includes the maximum
4.25% initial sales charge, all fund expenses and account fees. If operating
expenses such as the Franklin Strategic Mortgage Portfolio's had been applied to
the index, it's performance would have been lower. Please remember that an index
is simply a measure of performance, and one cannot invest in it directly.
3. Assumes shares were purchased and held for the entire accrual period. Since
dividends accrue daily, your actual distributions will vary, depending on the
date you purchased your shares and any account activity during the period.
GRAPHIC MATERIAL 2 OMMITTED - SEE APPENDIX AT END OF DOCUMENT
4. Total return shows the change in value of a $10,000 investment in the
Franklin Strategic Mortgage Portfolio and the unmanaged Salomon Brothers
Mortgage Index over the period indicated. Return calculations for the fund
include the maximum 4.25% initial sales charge, and assume reinvestment of
dividends and capital gains at net asset value. The Salomon Brothers Mortgage
Index is unmanaged, and one cannot invest directly in an index.
Franklin Strategic Mortgage Portfolio5
Periods ended September 30, 1995
Since
One- Inception
Year (2/1/93)
NAV Cumulative Total Return:6 13.27% 18.28%
NAV Average Annual Total Return:7 13.27% 6.51%
POP Average Annual Total Return:8 8.43% 4.80%
30-Day Standardized Yield:9 7.16%
Distribution Rate:10 7.16%
5. The manager of the Franklin Strategic Mortgage Portfolio has agreed in
advance to waive all of its management fees, which reduces operating expenses
and increases the distribution rate, yield and total return to shareholders. If
the manager had not taken this action, the fund's distribution rate and total
return would have been lower, and the 30-day yield would have been 6.08%. The
fee waiver may be discontinued at any time upon notice to the fund's Board of
Directors.
6. NAV cumulative total return does not include the current maximum 4.25%
initial sales charge and reflects the change in value of an investment over the
periods indicated, assuming reinvestment of dividends and capital gains at net
asset value.
7. NAV average annual total return does not include the current maximum 4.25%
initial sales charge and represents the average annual change in value of an
investment over the specified periods, assuming reinvestment of dividends and
capital gains at net asset value.
8. POP average annual total return includes the current maximum 4.25% initial
sales charge and represents the average annual change in value of an investment
over the stated periods, assuming reinvestment of dividends and capital gains at
net asset value. Prior to July 1, 1994, fund shares were offered at a higher
initial sales charge. Thus, actual total returns for purchasers of shares during
that period would have been somewhat lower than that noted above.
9. Yield, calculated as required by the SEC, is based on earnings of the fund's
portfolio during the 30 days ended on the date shown.
10. Based on an annualization of the fund's dividend for the 30-day period
($0.060946 per share) and the maximum offering price of $10.35 per share on
September 30, 1995. Investment return and principal value will fluctuate with
market conditions, and you may have a gain or loss when you sell your shares.
Past performance cannot guarantee future results.
<TABLE>
<CAPTION>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Statement of Investments in Securities and Net Assets, September 30, 1995
Face Value
Amount (Note 1)
<S> <C> <C>
$000,000 b,c Mortgage-Backed Securities 98.7%.................................................. $0,000,000)
Federal Home Loan Mortgage Corp. (FHLMC) 33.0%
$146,638 FHLMC, 9.00%, 06/01/01 ............................................................ $ 151,450
250,382 FHLMC, 6.50%, 11/01/01 ............................................................ 249,755
135,806 FHLMC, 6.50%, 03/01/09 ............................................................ 133,982
93,670 FHLMC, 7.00%, 06/01/09 ............................................................ 94,081
85,254 FHLMC, 8.00%, 01/01/10 ............................................................ 87,652
99,451 FHLMC, 7.50%, 04/01/10 ............................................................ 101,285
150,206 FHLMC, 6.00%, 07/01/10 ............................................................ 145,654
127,817 FHLMC, 9.50%, 12/01/22 ............................................................ 135,205
131,158 FHLMC, 7.00%, 06/01/24 ............................................................ 129,478
149,941 FHLMC, 7.50%, 07/01/24 ............................................................ 151,113
145,285 FHLMC, 8.00%, 07/01/24 ............................................................ 148,736
200,893 FHLMC, 8.50%, 12/01/24 ............................................................ 208,111
49,999 FHLMC, 8.00%, 06/01/25 ............................................................ 51,187
75,000 FHLMC, 7.00%, 09/01/25 ............................................................ 74,039
60,000 a FHLMC, 7.00%, 09/01/25 ............................................................ 59,231
50,000 a FHLMC, 7.50%, 09/01/25 ............................................................ 50,391
-----------
Total Federal Home Loan Mortgage Corp. (Cost $1,927,160)..................... 1,971,350
-----------
Federal National Mortgage Assocation (FNMA) 38.6%
219,184 FNMA, 6.00%, 03/01/01 ............................................................. 215,175
143,402 FNMA, 6.50%, 09/01/08 ............................................................. 141,431
95,139 FNMA, 7.00%, 07/01/09 ............................................................. 95,496
90,183 FNMA, 7.50%, 07/01/09 ............................................................. 91,790
28,650 FNMA, 6.00%, 12/01/23 ............................................................. 26,985
476,502 FNMA, 6.50%, 06/01/24 ............................................................. 459,526
401,850 FNMA, 7.00%, 06/01/24 ............................................................. 396,324
98,798 FNMA, 8.50%, 07/01/24 ............................................................. 102,349
246,781 FNMA, 9.00%, 12/01/24 ............................................................. 258,193
222,658 FNMA, 8.00%, 01/01/25 ............................................................. 227,948
238,887 FNMA, 7.50%, 08/01/25 ............................................................. 240,529
50,000 a FNMA, 7.50%, 09/01/25 ............................................................. 50,344
-----------
Total Federal National Mortgage Assocation (Cost $2,207,406)................. 2,306,090
-----------
Government National Mortgage Association (GNMA) 27.1%
165,323 GNMA, SF, 9.00%, 12/15/16 ......................................................... 174,208
111,808 GNMA, SF, 10.00%, 10/15/18 ........................................................ 122,011
135,997 GNMA, SF, 9.50%, 10/15/20 ......................................................... 145,346
230,776 GNMA, SF, 8.00%, 02/15/23 ......................................................... 237,555
288,025 GNMA, SF, 7.00%, 06/15/23 ......................................................... 284,784
183,566 GNMA, SF, 7.50%, 06/15/23 ......................................................... 185,459
285,846 GNMA, SF, 6.50%, 01/15/24 ......................................................... 275,842
$ 91,935 GNMA, SF, 8.50%, 09/15/24 ......................................................... $ 95,871
50,000 a GNMA, SF, 8.00%, 09/01/25 ......................................................... 51,468
49,500 GNMA, SF, 7.50%, 09/15/25 ......................................................... 50,010
-----------
Total Government National Mortgage Association (Cost $1,609,974) ............ 1,622,554
-----------
Total Mortgage-Backed Securities (Cost $5,744,540) .......................... 5,899,994
-----------
b,c Receivables from Repurchase Agreements 4.2%
259,521 Joint Repurchase Agreement, 6.429%, 10/02/95 (Cost $254,525)
Daiwa Securities America, Inc., (Maturity Value $124,784)
Collateral: U.S. Treasury Bills, 03/28/96
Swiss Bank Corp., (Maturity Value $129,877)
Collateral: U.S. Treasury Notes, 6.125% - 6.75%, 05/15/97 - 08/31/00 ............ 254,525
-----------
Total Investments (Cost $5,999,065) 102.9% ............................. 6,154,519
Liabilities in Excess of Other Assets, Net (2.9%) ...................... (174,613)
-----------
Net Assets 100.0% ...................................................... $5,979,906
===========
At September 30, 1995, the net unrealized appreciation based on the cost of
investments for income tax purposes of $5,999,065 was as follows:
Aggregate gross unrealized appreciation for all investments in which there was an
excess of value over tax cost .................................................. $ 178,153
Aggregate gross unrealized depreciation for all investments in which there was an
excess of tax cost over value .................................................. (22,699)
-----------
Net unrealized appreciation ..................................................... $ 155,454
===========
PORTFOLIO ABBREVIATIONS:
SF - Single Family
aSee Note 1(f) regarding securities purchased on a when-issued or delayed delivery basis.
bFace amount for repurchase agreements is for the underlying collateral.
cSee Note 1(e) regarding Joint Repurchase Agreement.
The accompanying notes are an integral part of these financial statements.
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements
Statement of Assets and Liabilities
September 30, 1995
Assets:
Investments in securities, at value
(identified cost $5,744,540) $5,899, 994
Receivables from repurchase agreements,
at value and cost 254,525
Receivables:
Interest 35,931
Investment securities sold 903
Unamortized organization costs (Note 2) 15,638
------------
Total assets 6,206,991
------------
Liabilities:
Payables:
Investment securities purchased
on a when-issued basis (Note 1) 211,092
Accrued expenses and other liabilities 15,993
------------
Total liabilities 227,085
------------
Net assets, at value $5,979,906
============
Net assets consist of:
Unrealized appreciation on investments $ 155,454
Accumulated realized loss (192,789)
Capital shares 6,037
Additional paid-in capital 6,011,204
------------
Net assets, at value $5,979,906
============
Computation of net asset value and
offering price per share:
Net asset value
($5,979,906 O 603,712 shares
outstanding) $ 9.91
============
Maximum offering price
(100/95.75 of $9.91) $ 10.35
============
Statement of Operations
for the year ended September 30, 1995
Investment income:
Interest (Note 1) $412,210
------------
Total income $412,210
Expenses:
Management fees, net (Note 6) --
Registration fees 16,303
Professional fees 12,731
Reports to shareholders 9,639
Amortization of organization costs
(Note 2) 6,951
Custodian fees 547
Other 396
Payments from Manager (Note 6) (46,567)
------------
Total expenses --
------------
Net investment income 412,210
------------
Realized and unrealized gain (loss)
on investments:
Net realized loss (76,041)
Net unrealized appreciation 355,238
------------
Net realized and unrealized gain on
investments 279,197
------------
Net increase in net assets resulting
from operations $691,407
============
The accompanying notes are an integral part of these financial statements.
<TABLE>
<CAPTION>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO Financial Statements (cont.)
Statements of Changes in Net Assets
for the years ended September 30, 1995 and 1994
1995 1994
-------- --------
<S> <C> <C>
Increase (decrease) in net assets:
Operations:
Net investment income.............................................................. $ 412,210 $ 297,090
Net realized loss on investments................................................... (76,041) (116,748)
Net unrealized appreciation (depreciation) on investments.......................... 355,238 (263,282)
-------- --------
Net increase (decrease) in net assets resulting from operations............... 691,407 (82,940)
Distributions to shareholders from:
Undistributed net investment income................................................ (412,210) (297,090)
Net realized capital gains......................................................... __ (56,643)
Increase in net assets from capital share transactions (Note 4)..................... 477,399 354,415
-------- --------
Net increase (decrease) in net assets......................................... 756,596 (82,258)
Net assets (there is no undistributed net investment income at beginning or end of year):
Beginning of year.................................................................. 5,223,310 5,305,568
-------- --------
End of year........................................................................ $5,979,906 $5,223,310
======== ========
The accompanying notes are an integral part of these financial statements.
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements
1. SIGNIFICANT ACCOUNTING POLICIES
Franklin Strategic Mortgage Portfolio (the Fund) is an open-end, diversified
management investment company (mutual fund) registered under the Investment
Company Act of 1940 as amended.
The following is a summary of the significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles for
investment companies.
a. Security Valuation:
Portfolio securities listed on a securities exchange or on the NASDAQ National
Market System for which market quotations are readily available are valued at
the last quoted sale price of the day or, if there is no such reported sale,
within the range of the most recent quoted bid and asked prices. Other
securities for which market quotations are readily available are valued at
current market values, obtained from pricing services, which are based on a
variety of factors, including recent trades, institutional size trading in
similar types of securities (considering yield, risk and maturity) and/or
developments related to specific securities. Portfolio securities which are
traded both in the over-the-counter market and on a securities exchange are
valued according to the broadest and most representative market as determined by
the Manager. Other securities for which market quotations are not available, if
any, are valued in accordance with procedures established by the Board of
Trustees.
b. Income Taxes:
The Fund intends to continue to qualify for the tax treatment applicable to
regulated investment companies under the Internal Revenue Code and to make the
requisite distributions to its shareholders which will be sufficient to relieve
it from income and excise taxes. Therefore, no income tax provision is required.
c. Security Transactions:
Security transactions are accounted for on the date the securities are purchased
or sold (trade date). Realized gains and losses on security transactions are
determined on the basis of specific identification for both financial statement
and income tax purposes.
d. Investment Income, Expenses and Distributions:
Distributions to shareholders are recorded on the ex-dividend date. Interest
income and estimated expenses are accrued daily. Bond discount and premium, if
any, are amortized as required by the Internal Revenue Code. The Fund normally
declares dividends from its net investment income daily and distributes monthly.
Daily allocations of net investment income will commence on the date following
receipt of an investor's funds. Dividends are normally declared each day the New
York Stock Exchange is open for business and are equal to the Fund's total net
investment income and are payable to shareholders of record at the beginning of
business on the ex-date. Once each month, dividends are reinvested in additional
shares of the Fund or paid in cash as requested by the shareholders.
e. Repurchase Agreements:
The Fund may enter into a Joint Repurchase Agreement whereby its uninvested cash
balance is deposited into a joint cash account to be used to invest in one or
more repurchase agreements with government securities dealers recognized by the
Federal Reserve Board and/or member banks of the Federal Reserve System. The
value and face amount of the Joint Repurchase Agreement are allocated to the
Fund based on its pro-rata interest. In a repurchase agreement, the Fund
purchases a U.S. government security from a dealer or bank subject to an
agreement to resell it at a mutually agreed upon price and date. Such a
transaction is accounted for as a loan by the Fund to the seller, collateralized
by the
1. SIGNIFICANT ACCOUNTING POLICIES (cont.)
e. Repurchase Agreements: (cont.)
underlying security. The transaction requires the initial collateralization of
the seller's obligation by U.S. government securities with market value,
including accrued interest, of at least 102% of the dollar amount invested by
the Fund, with the value of the underlying security marked to market daily to
maintain coverage of at least 100%. The collateral is delivered to the Fund's
custodian and held until resold to the dealer or bank. At September 30, 1995,
all outstanding repurchase agreements held by the Fund had been entered into on
September 29, 1995.
f. Securities Purchased on a When-Issued or Delayed Delivery Basis:
The Fund may trade securities on a when-issued or delayed delivery basis, with
payment and delivery scheduled for a future date. These transactions are subject
to market fluctuations and are subject to the risk that the value at delivery
may be more or less than the trade date purchase price. Although the Fund will
generally purchase these securities with the intention of acquiring such
securities, they may sell such securities before the settlement date. These
securities are identified on the accompanying statement of investments in
securities and net assets. The Fund has set aside sufficient investment
securities as collateral for these purchase commitments.
g. Mortgage Dollar Rolls:
The Fund may enter into mortgage dollar rolls in which the Fund sells
mortgage-backed securities and simultaneously contracts to repurchase
substantially similar, but not identical, securities on a specified future date,
generally at a price lower than the price of the security sold. The counterparty
receives all principal and interest payments, including prepayments, made on the
mortgage-backed security sold while it is the holder. Mortgage dollar rolls may
be renewed with a new sale and repurchase price fixed and a cash settlement made
without physical delivery of the securities subject to the contract, at the
renewal date. Mortgage dollar rolls are accounted for as non-collateralized
financing transactions.
2. UNAMORTIZED ORGANIZATION COSTS
The organization costs of the Fund are amortized on a straight line basis over a
period of five years from February 1, 1993, the effective date of registration
under the Securities Act of 1933. In the event that Franklin Resources, Inc.
(which was the sole shareholder prior to February 1, 1993) redeems its shares
within the five-year period, the pro-rata share of the then-unamortized deferred
organization costs will be deducted from the redemption price paid to Franklin
Resources, Inc. New investors purchasing shares of the Fund subsequent to that
date bear such costs during the amortization period only as such charges are
accrued daily against investment income.
3. DISTRIBUTIONS AND CAPITAL LOSS CARRYOVERS
At September 30, 1995, for tax purposes, the Fund had capital loss carryovers as
follows:
Expiring in:2002 .............. $116,748
2003 .............. 76,041
--------
$192,789
========
For tax purposes, the aggregate cost of securities and unrealized appreciation
are the same as for financial statement purposes at September 30, 1995.
<TABLE>
<CAPTION>
4. CAPITAL STOCK
At September 30, 1995, there were an unlimited number of $.01 par value shares
of beneficial interest authorized. Transactions for the years ended September
30, 1995 and 1994 were as follows:
Year Ended September 30,
--------------------------------------
1995 1994
--------------- ---------------
Shares Amount Shares Amount
------ ------- ----- -------
<S> <C> <C> <C> <C>
Shares sold........................................................ 29,120 $287,035 1,960 $ 19,375
Shares issued in reinvestment of distributions..................... 42,581 410,235 36,036 353,730
Shares redeemed.................................................... (21,277) (209,778) __ __
Changes from exercise of exchange privilege:
Shares sold....................................................... 928 8,811 __ __
Shares redeemed................................................... (1,951) (18,904) (1,939) (18,690)
------ ------- ----- -------
Net increase....................................................... 49,401 $477,399 36,057 $354,415
====== ======= ===== =======
</TABLE>
5. PURCHASESANDSALESOFSECURITIES
Purchases and sales of securities (excluding purchases and sales of short-term
securities and mortgage dollar roll transactions) for the year ended September
30, 1995 aggregated $2,429,699 and $1,803,906, respectively.
6. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES
Franklin Institutional Services Corporation (FISCO), under the terms of a
management agreement, provides investment advice, administrative services,
office space and facilities to the Fund, and receives fees computed and paid
monthly at the annual rate of .40 of 1% of average daily net assets up to and
including $250 million; .38 of 1% of average daily net assets in excess of $250
million, up to and including $500 million; and .36 of 1% of average daily net
assets in excess of $500 million. The terms of the management agreement provide
that annual aggregate expenses of the Fund be limited to the extent necessary to
comply with the limitations set forth in the laws, regulations and
administrative interpretations of the states in which the Fund's shares are
registered. The Fund's expenses did not exceed these limitations. However, for
the year ended September 30, 1995, FISCO agreed in advance to waive the $22,219
of management fees and made payments of $46,567 for other expenses as shown in
the Statement of Operations.
In its capacity as underwriter for the shares of the Fund, Franklin/Templeton
Distributors, Inc. received commissions on sales of the Fund's shares for the
year ended September 30, 1995, totalling $2,988 of which $2,786 was paid to
other dealers. Commissions are deducted from the gross proceeds received from
the sale of shares of the Fund and as such are not expenses of the Fund.
Pursuant to a shareholder service agreement with Franklin/Templeton Investors
Services, Inc., the Fund pays costs on a per shareholder account basis. Fees
which would have been incurred by the Fund but were borne by Franklin/Templeton
Investors Services, Inc., totalled $97.
At September 30, 1995, Franklin Resources, Inc. owned 98.85% of the Fund's
outstanding shares.
Certain officers and trustees of the Fund are also officers and/or directors of
FISCO, Franklin/Templeton Distributors, Inc., and Franklin/Templeton Investors
Services, Inc., all wholly-owned subsidiaries of Franklin Resources, Inc.
<TABLE>
<CAPTION>
7. FINANCIALHIGHLIGHTS
Selected data for each share of beneficial interest outstanding throughout each
year are as follows:
February 1, 1993
Year ended September 30, (effective date) to
-------------------------------
1995 1994 September 30, 1993
------------ ------------ ------------
<S> <C> <C> <C>
Per Share Operating Performance:
Net asset value at beginning of year................... $9.42 $10.24 $10.00
------------ ------------ ------------
Net investment income.................................. .714 .553 .365
Net realized and unrealized gain (loss) on securities.. .490 (.711) .240
------------ ------------ ------------
Total from investment operations....................... 1.204 (.158) .605
------------ ------------ ------------
Less distributions:
Dividends from net investment income................... (.714) (.553) (.365)
Distributions from realized capital gains.............. -- (.109) --
------------ ------------ ------------
Total distributions.................................... (.714) (.662) (.365)
------------ ------------ ------------
Net asset value at end of year......................... $9.91 $ 9.42 $10.24
============ ============ ============
Total Return+.......................................... 13.27% (1.61)% 6.13%
Ratios/Supplemental Data:
Net assets at end of year (in 000's)................... $5,980 $5,223 $5,306
Ratio of operating expenses to average net assets .... --% --% --%
Ratio of operating expenses to average net assets
(excluding waiver) (Note 6)........................... 1.24% 1.28% 1.22%*
Ratio of net investment income to average net assets... 7.42% 5.65% 3.59%*
Portfolio turnover rate ............................. 34.20% 86.38%** 104.33%**
*Annualized
+++The portfolio turnover rate excludes mortgage dollar roll transactions.
**The portfolio turnover rates for these periods have been restated to exclude
purchases and sales of mortgage dollar roll transactions.
+Total return measures the change in value of an investment over the periods
indicated. It is not annualized. It does not include the maximum initial sales
charge and assumes reinvestment of dividends and capital gains, if any, at net
asset value.
++During the year, FISCO agreed in advance to waive the management fees and made
payments of other expenses incurred by the Fund.
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Report of Independent Auditors
To the Shareholders and Board of Trustees
of Franklin Strategic Mortgage Portfolio
We have audited the accompanying statement of assets and liabilities of Franklin
Strategic Mortgage Portfolio, including the statement of investments in
securities and net assets, as of September 30, 1995, and the related statement
of operations for the year then ended, the statements of changes in net assets
for each of the two years in the period then ended, and the financial highlights
for the periods indicated thereon. These financial statements and financial
highlights are the responsibility of the Fund's management. Our responsibility
is to express an opinion on these financial statements and financial highlights
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and financial
highlights are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of securities owned as of
September 30, 1995, by correspondence with the custodian and brokers. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of
Franklin Strategic Mortgage Portfolio as of September 30, 1995, the results of
its operations for the year then ended, the changes in its net assets for each
of the two years in the period then ended, and the financial highlights for the
periods indicated thereon, in conformity with generally accepted accounting
principles.
COOPERS & LYBRAND L.L.P.
San Francisco, California
November 3, 1995
To ensure the highest quality of service, telephone calls to or from our service
departments may be monitored, recorded and accessed. These calls can be
determined by the presence of a regular beeping tone.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
APPENDIX
DESCRIPTION OF GRAPHIC MATERIAL OMITTED FROM EDGAR FILING
(PURSUANT TO ITEM 304 (a) of REGULATION S-T)
GRAPHIC MATERIAL (1)
This chart shows in pie chart format the fund's securities breakdown by issuer
as a percentage of the fund's total net assets.
<TABLE>
<CAPTION>
Investment Holdings on 9/30/95
<S> <C>
Government National Mortgage Association (GNMA) 38.6%
Federal Home Loan Mortgage Corporation (FHLMC) 33.0%
Federal National Mortgage Association (FNMA) 27.1%
Cash and Equivalents 1.3%
</TABLE>
GRAPHIC MATERIAL(2)
The following line graph hypothetically compares the performance of The Franklin
Strategic Mortgage Portfolio to that of the Salomon Brothers Mortgage Index,
based on a $10,000 investment from 2/1/93 to 9/30/95.
<TABLE>
<CAPTION>
Franklin Strategic Salomon Brothers
Period Ending Mortgage Portfolio Mortgage Index
<S> <C> <C>
2/1/93 $9,579 $10,000
2/28/93 $9,718 $10,092
3/31/93 $9,780 $10,153
4/30/93 $9,839 $10,222
5/31/93 $9,859 $10,269
6/30/93 $10,008 $10,368
7/31/93 $10,014 $10,411
8/31/93 $10,130 $10,453
9/30/93 $10,166 $10,463
10/30/93 $10,215 $10,497
11/30/93 $10,133 $10,478
12/31/93 $10,230 $10,557
1/31/94 $10,349 $10,664
2/28/94 $10,187 $10,598
3/31/94 $9,984 $10,336
4/30/94 $9,932 $10,271
5/31/94 $9,959 $10,306
6/30/94 $9,925 $10,280
7/31/94 $10,109 $10,480
8/31/94 $10,139 $10,502
9/30/94 $10,002 $10,362
10/31/94 $9,978 $10,358
11/30/94 $9,952 $10,321
12/31/94 $10,043 $10,407
1/31/95 $10,248 $10,640
2/28/95 $10,511 $10,911
3/31/95 $10,546 $10,956
4/30/95 $10,685 $11,103
5/31/95 $11,033 $11,463
6/30/95 $11,101 $11,523
7/31/95 $11,116 $11,546
8/31/95 $11,228 $11,653
9/30/95 $11,329 $11,756
</TABLE>
