MESSAGE FROM THE CHAIRMAN
===============================================================================
November 15, 1996
Dear Shareholder:
It's a pleasure to bring you the Franklin Strategic Mortgage Portfolio's annual
report for the period ended September 30, 1996.
During the first three months of the reporting period, economic growth remained
slow. Gross Domestic Product (GDP) in the fourth quarter of 1995 grew at an
annualized rate of only .3% amidst some speculation that the economy would slip
into a recession. This concern may have contributed to the 30-year U.S. Treasury
bond's yield dipping below 6% at the end of 1995.
The story in 1996 was somewhat different: rising employment and strong personal
income growth helped consumer spending rebound midway through the first quarter
of 1996. GDP growth,
calculated at an annualized rate of 2.2% in March 1996, increased to more than
4% by June -- raising inflationary concerns. This worry caused bond prices to
drop and long-term interest rates to rise throughout 1996.
As the third quarter of 1996 ended, the unemployment rate remained low, leading
many bond investors to speculate that economic growth could accelerate and
eventually lead to increased inflation. The Fed had lowered the target federal
funds rate in December 1995 and January 1996 in the wake of slow growth. Fed
Chairman Alan Greenspan noted later this year that increasing inflationary
pressures could lead to an increase in the federal funds rate but, to the
surprise of many analysts, took no action at the Open Market Committee Meeting
on September 24, 1996.
Relatively stable inflation rates, however, have managed to keep interest rates
from climbing as high as they did in 1994. Consumer credit problems in the U.S.
and lower-than-expected economic growth from the U.S.'s major trading partners
- -- among these, Germany, Japan and Mexico -- also kept interest rates in a
stable range during the second and third quarters of 1996.
We expect that your fund should perform well as the U.S. economy maintains its
current, relatively slow-growth course. While the economy appears to be stable
at the moment, market uncertainties persist.
We encourage you to maintain a long-term perspective. Periodically consult with
your investment representative to ensure your investments match these goals.
This long-term orientation will help minimize undue concern caused by short-term
market volatility.
As a Franklin Templeton fund shareholder, you receive the benefits of
professional management and dedicated service. We welcome the opportunity to
answer any questions concerning your fund.
We appreciate your support, welcome new shareholders and look forward to serving
your investment needs in the years ahead.
Sincerely,
Charles B. Johnson
Chairman
Franklin Strategic Mortgage Portfolio
===============================================================================
MANAGER'S DISCUSSION
================================================================================
Your Fund's Objective:
Seeks to obtain a high level of total return relative to the performance of the
general mortgage securities market 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.*
*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 the timely payment of principal and interest. Yields and share price are not
guaranteed and will fluctuate with market conditions.
U.S. mortgage securities performed well, in terms of total return, in comparison
to other federal government bonds. With long-term interest rates on the rise for
eight of the reporting period's twelve months, fewer people refinanced their
home mortgages, which reduced the prepayment risk for mortgage securities. This
reduction attracted investors to the mortgage security market.
As you know, we employ a consistent, disciplined and conservative approach to
investing in the mortgage passthrough market. Over the reporting period, this
market became increasingly divided into subsets based on the seasoning of the
underlying mortgage pools. These pools, characterized by varying degrees of risk
exposure to interest rate movement and housing cycles, exhibit different
prepayment patterns. The emergence of these subsets provided us with increased
opportunities to add quality securities to the fund.
Our investment approach, which utilizes low portfolio turnover, reduces
unnecessary transaction costs. During the 12-month period, we purchased
securities in several coupon and maturity ranges, including those in the 15- and
30-year maturity range. Interest rate exposure increased over the year due to
lower prepayments experienced by mortgage passthrough securities.
GRAPHIC MATERIAL 1 OMITTED - SEE APPENDIX AT END OF DOCUMENT
We have always employed a consistent, disciplined approach to investing in the
mortgage passthrough market and will continue to do so.
================================================================================
What is a "passthrough" security?
A mortgage security is an interest in a pool of mortgage loans. Most mortgage
securities are passthrough securities, which means that they provide investors
with monthly payments consisting of a prorated share of both regular interest
and principal payments -- as well as unscheduled early prepayments -- on the
underlying mortgage pool. The primary issuers or guarantors of these mortgage
securities are the Government National Mortgage Association (GNMA), Federal
National Mortgage Association (FNMA), and Federal Home Loan Mortgage Corporation
(FHLMC). Securities issued by these agencies are generally considered to be high
quality investments having minimal credit risks.
================================================================================
Performance Summary
The Franklin Strategic Mortgage Portfolio's share price, as measured by net
asset value, declined 17 cents from $9.91 on September 30, 1995, to $9.74 on
September 30, 1996.
At the end of this reporting period, the fund's distribution rate was 6.97%,
based on an annualization of the current dividend of 5.8267 cents ($0.058267)
per share and the maximum offering price of $10.17 on September 30, 1996.
Dividends will vary based on the earnings of the fund's portfolio, and past
distributions are not indicative of future trends.
Franklin Strategic Mortgage Portfolio
Dividend Distributions 10/1/95 - 9/30/96+
Dividend
Month per Share
October 6.2195 cents
November 5.8870 cents
December 5.6022 cents
January 6.3953 cents
February 5.9646 cents
March 5.6086 cents
April 6.4699 cents
May 5.9725 cents
June 5.2872 cents
July 6.5323 cents
August 5.6954 cents
September 6.0176 cents
Total 71.6521 cents
+Assumes shares were purchased and held for the entire accrual period. Since
dividends accrue daily, your actual distributions will vary depending on the day
you purchased your shares and any account activity during the month. Income
distributions and total return calculations include all accrued income earned by
the fund during the reporting period.
The chart on page 6 illustrates that since its inception in 1993, the Franklin
Strategic Mortgage Portfolio underperformed the unmanaged Salomon Brothers
Mortgage Index. Comparing a mutual fund with an index, however, is neveran
apples-to-apples comparison. Unmanaged indices don't pay management fees to
cover salaries of securities analysts or portfolio managers, or pay commissions
or market spreads to buy and sell securities. Also, unlike indices, mutual funds
are never fully invested because they must have cash on hand to redeem shares.
In addition, the performance shown for the fund includes the maximum initial
sales charge, all fund expenses and account fees. If the fund's costs had been
applied to the index, the index's performance would have been lower. Please
remember that an index is simply a measure of performance and cannot be invested
in directly. Past performance is not predictive of future results.
GRAPHIC MATERIAL 2 OMITTED - SEE APPENDIX AT END OF DOCUMENT
Franklin Strategic Mortgage Portfolio
Periods ended September 30, 1996
Since
Inception
1-Year 3-Year (2/1/93)
- --------------------------------------------------------------------------------
Cumulative Total Return1 5.69% 17.78% 25.00%
Average Annual Total Return2 1.19% 4.10% 5.04%
Distribution Rate3 6.97%
30-Day Standardized Yield4 6.96%
- --------------------------------------------------------------------------------
1. Cumulative total return measures the change in value of an investment over
the periods indicated and does not include
sales charges. See Note below.
2. Average annual total return measures the average annual change in value of an
investment over the periods indicated and includes the 4.25% initial sales
charge. See Note below.
3. Distribution rate is based on the annualization of the current 5.8267 cent
per share monthly dividend and the maximum offering price of $10.17 on September
30, 1996.
4. Yield, calculated as required by the SEC, is based on the earnings
of the fund's portfolio for the 30 days ended September 30, 1996.
Note: 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 different than noted above. Your 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 is not predictive of future
results.
The fund's manager has agreed to waive a portion of management fees, which
reduces operating expenses and increases 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 yield for the
period would have been 5.72%. The fee waiver may be discontinued at any time
upon notice to the fund's Board of Directors.
================================================================================
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Statement of Investments in Securities and Net Assets, September 30, 1996
Face Value
Amount (Note 1)
-------------------------------------------------------------------------
Mortgage-Backed Securities 96.3%
Federal Home Loan Mortgage Corp. (FHLMC) 31.9%
$ 86,405 9.00%, 06/01/01 ........................... $ 90,105
206,177 6.50%, 11/01/01 ........................... 202,892
120,678 6.50%, 03/01/09 ........................... 117,096
82,109 7.00%, 06/01/09 ........................... 81,315
56,073 8.00%, 01/01/10 ........................... 57,352
75,949 7.50%, 04/01/10 ........................... 76,519
133,736 6.00%, 07/01/10 ........................... 126,966
73,568 6.50%, 04/01/11 ........................... 71,384
100,319 7.00%, 07/01/11 ........................... 99,348
104,528 9.50%, 12/01/22 ........................... 111,714
129,103 7.00%, 06/01/24 ........................... 124,988
129,632 7.50%, 07/01/24 ........................... 128,457
124,841 8.00%, 07/01/24 ........................... 126,285
158,787 8.50%, 12/01/24 ........................... 163,353
45,896 8.00%, 06/01/25 ........................... 46,427
74,205 7.00%, 09/01/25 ........................... 71,840
59,366 7.00%, 10/01/25 ........................... 57,474
47,251 7.50%, 10/01/25 ........................... 46,824
70,336 7.50%, 01/01/26 ........................... 69,699
89,045 8.00%, 01/01/26 ........................... 90,076
60,541 7.00%, 03/01/26 ........................... 58,611
120,549 7.00%, 03/01/26 ........................... 116,707
50,369 7.50%, 05/01/26 ........................... 49,913
---------
Total Federal Home Loan Mortgage Corp.(Cost $2,173,880) 2,185,345
---------
Federal National Mortgage Assocation (FNMA) 38.3%
194,249 6.00%, 03/01/01 ............................ 189,356
125,729 6.50%, 09/01/08 ............................ 121,918
90,490 7.00%, 07/01/09 ............................ 89,529
76,911 7.50%, 07/01/09 ............................ 77,464
50,499 6.50%, 04/01/11 ............................ 48,969
53,576 6.00%, 05/01/11 ............................ 50,831
50,498 6.00%, 06/01/11 ............................ 47,911
35,000a 7.00%, 10/01/11 ............................ 34,606
26,960 6.00%, 12/01/23 ............................ 24,618
468,972 6.50%, 06/01/24 ............................ 440,981
397,016 7.00%, 06/01/24 ............................ 383,742
89,765 8.50%, 07/01/24 ............................ 92,234
151,890 9.00%, 01/01/25 ............................ 153,457
26,470 9.00%, 01/01/25 ............................ 26,744
$ 166,589 9.00%, 01/01/25 ............................ 174,190
218,460 7.50%, 08/01/25 ............................ 216,208
100,000a 7.50%, 09/01/25 ............................ 98,906
49,546 7.50%, 11/01/25 ............................ 49,036
60,545 7.00%, 01/01/26 ............................ 58,521
50,180 7.50%, 03/01/26 ............................ 49,663
75,119 7.00%, 06/01/26 ............................ 72,607
30,178 8.00%, 06/01/26 ............................ 30,489
90,000a 8.00%, 10/01/26 ............................ 90,872
----------
Total Federal National
Mortgage Assocation (Cost $2,567,788)....... 2,622,852
----------
Government National Mortgage
Association (GNMA), SF, 26.1%
131,870 9.00%, 12/15/16 ............................ 138,464
68,624 10.00%, 10/15/18 ........................... 74,972
120,899 9.50%, 10/15/20 ............................ 129,853
199,744 8.00%, 02/15/23 ............................ 201,992
274,006 7.00%, 06/15/23 ............................ 264,160
158,126 7.50%, 06/15/23 ............................ 156,397
266,321 6.50%, 01/15/24 ............................ 249,177
129,826 8.50%, 07/15/24 ............................ 133,721
42,089 8.00%, 01/15/25 ............................ 42,563
49,073 7.50%, 09/15/25 ............................ 48,537
25,159 7.50%, 09/15/25 ............................ 24,884
35,000 a8.50%, 01/01/26 ............................ 36,017
50,331 7.00%, 01/15/26 ............................ 48,523
74,107 7.50%, 01/15/26 ............................ 73,297
25,228 7.00%, 03/15/26 ............................ 24,321
25,231 7.50%, 05/15/26 ............................ 24,955
39,901 8.00%, 06/15/26 ............................ 40,350
34,651 8.00%, 08/20/26 ............................ 34,868
40,000 a7.50%, 10/01/26 ............................. 39,540
----------
Total Government National
Mortgage Association (Cost $1,805,154)........ 1,786,591
-----------
Total Mortgage-Backed Securities
(Cost $6,546,822)............................. 6,594,788
-----------
bReceivables from Repurchase Agreement 7.5%
$ 511,512 Joint Repurchase Agreement, 5.687%, 10/01/96
(Maturity Value $509,914)
(Cost $509,834)
Aubrey G. Lanston & Co., Inc., (Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 6.00%, 09/30/98
Bear, Stearns & Co., Inc., (Maturity Value $62,852)
Collateral: U.S. Treasury Bills, 02/27/97
U.S.Treasury Notes, 5.75% - 5.875%, 08/15/98 - 10/31/00
Donaldson, Lufkin & Jenrette Securities Corp.,
(Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 4.75% - 8.50%,
07/15/97 - 08/15/01
Fuji Securities, Inc., (Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 5.75% - 6.75%,
05/31/97 - 04/30/00
Lehman Brothers, Inc., (Maturity Value $69,950)
Collateral: U.S. Treasury Notes, 5.125% - 8.00%,
02/28/98 - 06/30/01
SBC Warburg, Inc., (Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 6.00%, 05/31/98
The Nikko Securities Co. International, Inc.,
(Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 5.375% - 6.50%,
11/30/97 - 05/31/01
UBS Securities L.L.C., (Maturity Value $62,852)
Collateral: U.S. Treasury Notes, 5.75% - 7.375%,
07/31/97-11/15/97 ................................. $ 509,834
-----------
Total Investments (Cost $7,056,656) 103.8% .... 7,104,622
Liabilities in Excess of Other Assets (3.8)%... (257,397)
-----------
Net Assets 100.0% .............................. $6,847,225
===========
At September 30, 1996, the net unrealized appreciation based
on the cost ofinvestments for income tax purposes of $7,029,261
was as follows: Aggregate gross unrealized appreciation for all
investments in which there was an excess of value over tax
cost........................................................ $ 131,931
Aggregate gross unrealized depreciation for all investments
in which there was an excess of tax cost over value.......... (56,570)
---------
Net unrealized appreciation................................... $ 75,361
=========
PORTFOLIO ABBREVIATION:
SF - Single Family
aSee Note 1(g) regarding securities purchased on a when-issued basis.
bFace amount for repurchase agreements is for the underlying collateral. See
Note 1(f) regarding joint repurchase agreement.
Financial Statements
Statement of Assets and Liabilities
September 30, 1996
Assets:
Investments in securities, at value
(identified cost $6,546,822) $6,594,788
Receivables from repurchase agreements,
at value and cost 509,834
Receivables:
Interest 40,610
Investment securities sold 1,673
Unamortized organization cost (Note 2) 1,200
---------
Total assets 7,148,105
---------
Liabilities:
Payables:
Investment securities purchased
on a when issued basis (Note 1) 298,883
Dividends to shareholders 797
Accrued expenses and other liabilities 1,200
-----------
Total liabilities 300,880
Net assets, at value $6,847,225
===========
Net assets consist of:
Unrealized appreciation on investments 47,966
Net realized loss (192,789)
Capital shares 6,992,048
-----------
Net assets, at value $6,847,225
===========
Computation of net asset value and offering price per share:
Net asset value ($6,847,225 / 702,885
shares outstanding) 9.74
=========
Maximum offering price
(100/95.75 of $9.74) $10.17
==========
Statement of Operations
for the year ended September 30, 1996
Investment income:
Interest (Note 1) $461,328
Expenses:
Management fees, (Note 6) 25,479
Shareholder servicing costs (Note 6) 471
Registration fees 17,000
Amortization of organization
costs (Note 2) 14,438
Professional fees 9,964
Reports to shareholders 2,016
Custodian fees 167
Other 794
Management fees waived
by manager (Note 6) (25,479)
Other expenses assumed
by manager (Note 6) (44,850)
--------
Total expenses --
-------
Net investment income 461,328
-------
Net unrealized depreciation
on investments (107,488)
--------
Net increase in net assets
resulting from operations $353,840
=========
Statements of Changes in Net Assets
for the years ended September 30, 1996 and 1995
1996 1995
------ ------
Increase (decrease) in net assets:
Operations:
Net investment income................................ $ 461,328 $ 412,210
Net realized loss from investments................... -- (76,041)
Net unrealized appreciation (depreciation) on
investments......................................... (107,488) 355,238
--------- -------
Net Increase in net assets resulting from operations. 353,840 691,407
Distributions to shareholders from undistributed
net investment income................................ (461,328) (412,210)
Increase in net assets from capital share transactions
(Note 4) 974,807 477,399
--------- -------
Net increase in net assets.......................... 867,319 756,596
Net assets (there was no undistributed net investment
income at beginning or end of year):
Beginning of year................................... 5,979,906 5,223,310
--------- ---------
End of year.........................................$6,847,225 $5,979,906
========= =========
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 Fund seeks to provide investors with a high
level of total return, relative to the performance of the general mortgage
securities market.
The following is a summary of 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 for which
market quotations are readily available are valued at the last sale price or, if
there is no sale price, within the range of the most recent quoted bid and asked
prices. Other securities are valued based on a variety of factors, including
yield, risk, maturity, trade activity and recent developments related to the
securities. The Fund may utilize a pricing service, bank or broker/dealer
experienced in such matters to perform any of the pricing functions, under
procedures approved by the Board of Trustees (the Board). Securities for which
market quotations are not available are valued in accordance with procedures
established by the Board.
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.
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.
d. Investment Income, Expenses and Distributions:
Dividend income and distributions to shareholders are recorded on the
ex-dividend date. Interest income and estimated expenses are accrued daily. Bond
discount is 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 commence on the day
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 an amount
per day set from time to time by the Board, and are payable to shareholders of
record at the beginning of business on the ex-dividend date. Once each month
dividends are reinvested in additional shares of the Fund, or paid in cash as
requested by the shareholders.
e. Accounting Estimates:
The preparation of the financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the amounts of income and expense during
the reporting period. Actual results could differ from those estimates.
f. 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. A repurchase agreement is accounted for as
a loan by the Fund to the seller, collateralized by underlying U.S. government
securities, which are delivered to the Fund's custodian. The market value,
including accrued interest, of the initial collateralization is required to be
at least 102% of the dollar amount invested by the Fund with the value of the
underlying securities marked to market daily to maintain coverage of at least
100%. At September 30, 1996, all outstanding repurchase agreements held by the
Fund had been entered into on that date .
g. 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 holding the
securities, it may sell the 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.
h. 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).
3. DISTRIBUTIONS AND CAPITAL LOSS CARRYOVERS
At September 30, 1996, for tax purposes, the Fund had net capital loss
carryovers as follows:
Expiring in:.2002............ $109,092
2004............ 56,302
--------
$165,394
========
For tax purposes, the aggregate cost of securities is lower (and unrealized
appreciation is higher or unrealized depreciation is lower) than for financial
statement purposes at September 30, 1996 by $27,395.
From November 1, 1994 through September 30, 1995, the Fund incurred
approximately $56,474 of net realized capital losses. As permitted by tax
regulations, the Fund deferred these losses until October 1, 1995. Therefore,
these losses are treated as having arisen in the fiscal year ended September 30,
1996.
4. CAPITAL STOCK
At September 30, 1996, there were an unlimited number of $.01 par value shares
of beneficial interest authorized. Transactions in the Fund's shares for the
years ended September 30, 1996 and 1995 were as follows:
1996 1995
--------------- ----------------
Shares Amount Shares Amount
------ ------- ------ --------
Shares sold...................... 55,521 $545,307 30,048 $295,846
Shares issued in reinvestment of
distributions................... 46,337 455,627 42,581 410,235
Shares redeemed.................. (2,685) (26,127) (23,228) (228,682)
------ ------- ------ --------
Net increase..................... 99,173 $974,807 49,401 $477,399
======= ======== ======= =========
5. PURCHASES AND SALES OF SECURITIES
Purchases and sales of securities (excluding purchases and sales of short-term
securities and mortgage dollar roll transactions) for the year ended September
30, 1996 aggregated $1,878,727 and $1,076,079, respectively.
6. TRANSACTIONS WITH AFFILIATES AND RELATED PARTIES
a. Management Agreement:
Under the terms of a management agreement, Franklin Institutional Services
Corporation (FISCO), provides investment advice, administrative services, office
space and facilities to the Fund, and receives fees computed monthly based on
the average daily net assets of the Fund as follows:
Annualized Fee Rate Average Daily Net Assets
------------------- -----------------------------------
.400% First $250 million
.380% over $250 million, up to and including
$500 million
.360% over $500 million
The terms of the management agreement provide that aggregate annual 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. For the year ended September 30,
1996, the Fund's expenses did not exceed these limitations. However, FISCO
agreed in advance to waive management fees and made payments of other expenses
as shown in the Statement of Operations.
b. Shareholder Services Agreement:
Under the terms of a shareholder service agreement with Franklin/Templeton
Investors Services, Inc. (Investor Services), the Fund pays costs on a per
shareholder account basis. Shareholder servicing costs incurred by the Fund for
the year ended September 30, 1996 aggregated $471.
c. Underwriting Agreement:
In its capacity as underwriter for the shares of the Fund, Franklin/Templeton
Distributors, Inc. (Distributors) receives commissions on sales of the Fund's
shares of beneficial interest. 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. Distributors may also make payments, out of its own resources, to the
dealers for certain sales of the Fund's shares. Commissions received by
Distributors and the amounts paid to other dealers for the years ended September
30, 1996 amounted to $8,061 and $7,505, respectively.
d. Other Affiliated Parties and Transactions:
Certain officers and trustees of the Fund are also officers and/or directors of
FISCO, Distributors, and Investors Services, all wholly-owned subsidiaries of
Franklin Resources, Inc. (Resources).
At September 30, 1996, Resources owned 91.30% of the Fund's outstanding shares.
7. FINANCIAL HIGHLIGHTS
Selected data for each share of beneficial interest outstanding throughout each
period are as follows:
<TABLE>
<CAPTION>
Year ended September 30,
1996 1995 1994 1993***
------- ------ -------- --------
Per Share Operating Performance:
<S> <C> <C> <C> <C>
Net asset value at beginning of period.......... $ 9.91 $ 9.42 $10.24 $10.00
------- ------ -------- --------
Net investment income........................... .717 .714 .553 .365
Net realized and unrealized gain (loss) on
securities..................................... (.170) .490 (.711) .240
------- ------ -------- --------
Total from investment operations................ .547 1.204 (.158) .605
------- ------ -------- --------
Less distributions:
From net investment income...................... (.717) (.714) (.553) (.365)
From realized capital gains..................... -- -- (.109) --
------- ------ -------- --------
Total distributions............................. (.717) (.714) (.662) (.365)
------- ------ -------- --------
Net asset value at end of period................ $ 9.74 $ 9.91 $ 9.42 $10.24
======= ====== ======== ========
TotalReturn+.................................... 5.69% 13.27% (1.61)% 6.13%
Ratios/Supplemental Data:
Net assets at end of period (in 000's).......... $6,847 $5,980 $5,223 $5,306
Ratio of operating expenses to average net
assets++........................................ --% --% --% --%
Ratio of operating expenses to average net
assets
(excluding waiver and payments by Manager)
(Note 6)....................................... 1.11% 1.24% 1.28% 1.22%*
Ratio of net income to average net assets....... 7.26% 7.42% 5.65% 3.59%*
Portfolio turnover rate+++...................... 17.64% 34.20% 86.38%** 104.33%**
</TABLE>
+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.
+++The portfolio turnover rate excludes mortgage dollar roll transactions.
*Annualized
**The portfolio turnover rates for these periods have been restated to exclude
purchases and sales of mortgage dollar roll transactions.
***For the period February 1, 1993 (effective date) to September 30, 1993.
Franklin Strategic Mortgage Portfolio Annual Report 9/30/96.
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 format the fund's portfolio holdings on 9/30/96, as a
percentage of total net assets.
Investment Holdings on September 30, 1996
Federal National Mortgage 38.3%
Association (FNMA)
Federal Home Loan Mortgage 31.9%
Corporation (FHLMC)
Government National Mortgage 26.1%
Association (GNMA)
Cash & Equivalents 3.7%
GRAPHIC MATERIAL (2)
The following line graph hypothetically compares the performance of the fund's
shares with the Salomon Brothers Mortgage Index, based on a $10,000 investment
from 2/1/93 to 3/31/96.
Period Ending Fund Index
2/1/93 9579 $ 10,000
Feb-93 9,718 $ 10,092
Mar-93 9,780 $ 10,153
Apr-93 9,839 $ 10,222
May-93 9,859 $ 10,269
Jun-93 10,007 $ 10,368
Jul-93 10,014 $ 10,411
Aug-93 10,130 $ 10,453
Sep-93 10,166 $ 10,463
Oct-93 10,215 $ 10,497
Nov-93 10,133 $ 10,478
Dec-93 10,230 $ 10,557
Jan-94 10,349 $ 10,664
Feb-94 10,187 $ 10,598
Mar-94 9,984 $ 10,336
Apr-94 9,932 $ 10,271
May-94 9,959 $ 10,306
Jun-94 9,925 $ 10,280
Jul-94 10,109 $ 10,480
Aug-94 10,139 $ 10,502
Sep-94 10,002 $ 10,362
Oct-94 9,978 $ 10,358
Nov-94 9,952 $ 10,321
Dec-94 10,043 $ 10,407
Jan-95 10,248 $ 10,640
Feb-95 10,511 $ 10,911
Mar-95 10,546 $ 10,956
Apr-95 10,685 $ 11,103
May-95 11,033 $ 11,463
Jun-95 11,101 $ 11,523
Jul-95 11,116 $ 11,546
Aug-95 11,228 $ 11,653
Sep-95 11,329 $ 11,756
Oct-95 11,446 $ 11,864
Nov-95 11,571 $ 12,003
Dec-95 11,706 $ 12,152
Jan-96 11,803 $ 12,246
Feb-96 11,709 $ 12,149
Mar-96 11,658 $ 12,108
Apr-96 11,628 $ 12,052
May-96 11,591 $ 12,036
Jun-96 11,727 $ 12,190
Jul-96 11,782 $ 12,239
Aug-96 11,778 $ 12,242
Sep-96 11,974 $ 12,447
CUM. TR 19.74% 24.47%
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 Fund's statement of investments in
securities and net assets, as of September 30, 1996, 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 each of the periods presented. These financial statements and financial
highlights are the responsibility of the Funds' 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, 1996, 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 the
Fund as of September 30, 1996, 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 each of the periods presented, in
conformity with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
San Francisco, California
November 4, 1996
