Annual
Report
September 30, 1998
Franklin Strategic Mortgage Portfolio
Thank you for investing with Franklin Templeton. We encourage our investors to
maintain a long-term perspective and remember that all securities markets move
both up and down, as do mutual fund share prices. We appreciate your past
support and look forward to serving your investment needs in the years ahead.
GRAPHIC PICTURE OMITTED
Charles B. Johnson
Chairman
Franklin Strategic
Mortgage Portfolio
CONTENTS
Shareholder Letter .......... 1
Manager's Discussion ........ 4
Performance Summary ......... 7
Financial Highlights &
Statement of Investments .... 9
Financial Statements ........ 13
Notes to
Financial Statements ........ 16
Independent
Auditors' Report ............ 19
SHAREHOLDER LETTER
Dear Shareholder:
It's a pleasure to bring you the Franklin Strategic Mortgage Portfolio annual
report for the period ended September 30, 1998.
FOREIGN STORMS BRING RAIN
Although El Nino's effects on domestic weather subsided in June, the U.S. stock
market faced its own version of adverse elements in August. By the end of the
reporting period, financial events at home mirrored the downpour abroad, where
washed-out currencies flooded foreign markets. On August 31, storm clouds rained
on American stock markets, washing away much of the first half of 1998's
spectacular gains. On that day the Dow Jones(R) Industrial Average (DJIA) lost
512.61 points or 6.37% of its value.1 Many analysts attributed this slide to
concerns about Russia's economic and political stability as well as evidence
that the Asian countries' economic problems are more deep-seated than originally
believed. At home, 1998 U.S. corporate profits, through the end of the reporting
period, fell dramatically from 1997 levels. Those companies with significant
Asian exports, competing with Asian products or those in commodity businesses
like paper, oil and steel were especially hard hit.
At the same time, the very factors negatively impacting the U.S. stock market --
the slowing domestic economy and Russian and Asian economic turmoil -- provided
a boost to the U.S. bond market. Low inflation at home and foreign investors
flocking to U.S. bonds, especially U.S. Treasuries, as a "safe haven" from stock
market volatility abroad, drove bond prices higher. Bond price and yield move in
an inverse relationship, so yields on long-term bonds fell to their lowest
levels in years. The benchmark 30-year U.S. Treasury bond ended the reporting
period yielding 4.98%, compared with 6.41% a year earlier.2
1. Source: Bloomberg.
What is an investor to do faced with steeply fluctuating markets? While the
phrase "investment value may go down as well as up" abounds in financial
literature, the stock market's unusually high gains in the past few years may
have led many investors to believe otherwise. Putting the 1990s into historical
perspective, it is worth noting that the average yearly gain in the S&P 500(R),
which paints a broader picture of the U.S. market than the DJIA, has been
+10.51% since 1930; however, from January 1, 1990, through June 30, 1998, the
S&P 500 rose an average of +17.81% a year.3 Also, there have been fewer market
corrections during the 1990s than previous decades, with a market correction
being defined as a 10% or greater decline over a period of days, weeks or
months.
WEATHERPROOFING YOUR PORTFOLIO
In times like these, it's easy to understand why people can become emotional
about their investments. That's why I believe investors should call their
investment representatives, and plan to cover three points in their
conversations. One, review their current financial plans, recalling their goals
and why they made their investment choices in the first place. Two, discuss the
value of diversification, which can help reduce the risk that any one type of
security will have a negative impact on an overall portfolio, and check if their
investments are still properly diversified. As shown during the reporting
period, the bond and stock markets often behave differently. In each of the five
years since 1973 that stocks posted negative annual returns, bonds posted
positive returns.4 Three, review their investment timeframe to help put recent
market declines into perspective and avoid turning what could be only a
temporary paper loss into a permanent one. Maintaining a long-term outlook is
one of the keys to weathering market volatility.
2. Ibid.
3. Source: Stocks, Bonds, Bills, and Inflation 1998 Yearbook, Ibbotson
Associates.
An important component of a long-term approach is having a regular investment
plan. Investing on a scheduled basis, regardless of market directions, can help
investors take advantage of market downturns when prices are low, and benefit
from any market rallies. We encourage you to contact your investment
representative to discuss setting up a regular investment plan. While investment
success is the primary objective of investment planning, one important
by-product of a good plan can be peace of mind.
As always, we appreciate your support, welcome your questions and comments and
look forward to serving your investment needs in the years ahead.
Sincerely,
Charles B. Johnson
Chairman
Franklin Strategic Mortgage Portfolio
4. Source: For bond market statistics based on the Lehman Brothers Government/
Corporate Bond Index - Lehman Brothers; for stock market measured by the S&P 500
Index - Standard & Poor's(R).
MANAGER'S DISCUSSION
- --------------------------------------------------------------------------------
Your Fund's Goal: Franklin Strategic Mortgage Portfolio 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.1
- --------------------------------------------------------------------------------
Strong economic growth and low inflation characterized the United States economy
during the 12-month reporting period. Robust consumer demand was the primary
driver for the 3.6% annualized U.S. gross domestic product growth rate, from the
end of second quarter 1997, through second quarter 1998.2 An extremely strong
labor market, as seen in September's 4.6% unemployment rate, which hovered near
a 30-year low, supported high levels of consumer confidence during the reporting
period.2 A booming housing market, resulting from low unemployment as well as
falling interest rates, further contributed to economic growth during the
reporting period.
The presence of tight labor markets pushing up wage and benefit costs has not
yet translated into consumer price inflation. Commodity prices fell as the Asian
contagion stifled global demand. At the same time, productivity gains in the
U.S. allowed businesses to absorb rising labor costs without passing them on to
consumers. The unique combination of these two factors helped keep inflation
extremely low during the reporting period, as demonstrated by the Consumer Price
Index (CPI) increase of only 1.5% from September 30, 1997, to September 30,
1998.3
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 the timely payment of principal and interest. Yields and share price are not
guaranteed and will fluctuate with market conditions.
2. Source: Bloomberg.
You will find a complete listing of the fund's portfolio holdings, including
dollar value and number of shares or principal amount, beginning on page 10 of
this report.
Inflation's inability to ignite was one factor precipitating the U.S. interest
rate decline over the past year. 30-year Treasury interest rates fell 143 basis
points during the reporting period, from 6.41% to 4.98%. The federal budget
deficit reduction and U.S. Treasury securities' increased popularity among
investors also spurred falling interest rates.
Disruptions in the Asian economies sent shockwaves throughout global financial
markets, spurring investors' flight to quality into "safe haven" U.S. Treasury
securities. This surge in popularity, occurring during a period of reduced
supply, drove up the prices of Treasuries, causing their yields to fall during
the reporting period. At the same time, increased tax receipts, prompted by a
strong U.S. economy and the federal government's higher degree of fiscal
responsibility, reduced the need for Treasury borrowing, thereby lowering the
supply of Treasury securities on the market.
The flight to quality also led to the U.S. dollar's appreciation relative to
many currencies. As a consequence, U.S. products became more expensive and less
competitive with their foreign counterparts. In addition, the Asian crisis
exerted a drag on U.S. economic growth in early 1998, dampening exports and
manufacturing activity. Although bad news for the American trade deficit, the
influx of cheaper foreign goods reaching American shores should keep inflation
at bay. Anticipating that U.S. economic growth will slow under the weight of the
global financial crisis, the Federal Reserve Board lowered the Federal Funds
target rate to 5.25% on September 29.4
3. Source: Standard & Poor's Micropal.
GRAPHIC MATERIAL 1 OMITTED - SEE APPENDIX AT END OF DOCUMENT
The magnitude and abruptness of the late-summer Treasury market rally prevented
mortgage pass-throughs from keeping pace with comparable, recently issued
Treasury securities. In the midst of the global turmoil, it seemed that
investors shunned all other financial instruments in favor of U.S. Treasuries.
As a consequence, the yield spread widened between Treasury securities and
mortgage-backed securities.
Over the past twelve months, we increased our exposure to lower-coupon mortgage
pass-throughs, which offer more insulation from prepayment risk than
higher-coupon pass-throughs. Prepayment risk is the risk that the borrower will
take advantage of lower interest rates to refinance his home loan, repaying the
original mortgage holder ahead of time; thereby causing the mortgage holder to
lose this source of income. In such an environment the returned principal can
only be reinvested at the current, lower rates. We also held non-callable U.S.
Treasury and agency securities in the portfolio, anticipating they would benefit
from the lower interest-rate environment. We will look to add to our mortgage
securities holdings as relative value opportunities arise.
Please remember, this discussion reflects our views, opinions and portfolio
holdings as of September 30, 1998, the end of the reporting period. However,
market and economic conditions are changing constantly, which can be expected to
affect our strategies and the fund's portfolio composition. Although historical
performance is no guarantee of future results, these insights may help you
understand our investment and management philosophy.
4. Source: Bloomberg.
PERFORMANCE SUMMARY
The share price of Franklin Strategic Mortgage Portfolio, as measured by net
asset value, increased 18 cents, from $9.96 on September 30, 1997, to $10.14 on
September 30, 1998. During the one-year reporting period, shareholders received
dividend income totaling 65.887 cents ($0.65887). Distributions will vary based
on the fund's income, and past distributions are not predictive of future
trends.
Based on an annualization of the current monthly per-share dividend of 5.3196
cents ($0.053196) and the maximum offering price of $10.59 on September 30,
1998, your fund's distribution rate was 6.11%.
The chart on page 8 illustrates the performance of the fund since its inception
in 1993, compared with that of the Salomon Brothers Mortgage-Backed Securities
Index. Keep in mind an unmanaged index has inherent performance differentials in
comparison with any fund. An index doesn't pay management fees to cover salaries
of securities analysts or portfolio managers, or pay commissions or market
spreads to buy and sell securities. Unlike an index, mutual funds are never
fully invested because they need 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 operating expenses such as Franklin Strategic
Mortgage Portfolio's 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 one cannot invest in it directly.
Past performance is not predictive of future results.
Dividend Distributions
10/1/97 - 9/30/98*
Dividend
Month per share
- --------------------------------------------
October 5.7027 cents
November 5.4468 cents
December 6.2921 cents
January 5.3962 cents
February 5.3138 cents
March 5.5958 cents
April 5.0581 cents
May 5.0931 cents
June 5.7765 cents
July 5.5012 cents
August 5.3911 cents
September 5.3196 cents
- --------------------------------------------
Total 65.8870 cents
*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 month. Income
distributions include all accrued income earned by the fund during the reporting
period.
GRAPHIC MATERIAL 2 OMITTED - SEE APPENDIX AT END OF DOCUMENT
*Includes all sales charges as applicable, and represents the change in value of
an investment over the period shown. Total return assumes reinvestment of
dividends and capital gains at net asset value.
**Source: Standard and Poor's Micropal. Index is unmanaged and includes
reinvested dividends. One cannot invest directly in an index.
<TABLE>
<CAPTION>
Periods ended 9/30/98
SINCE
INCEPTION
1-YEAR 3-YEAR 5-YEAR (2/1/93)
- --------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Cumulative Total Return1 8.71% 26.20% 40.64% 49.26%
Average Annual Total Return2 4.11% 6.51% 6.14% 6.52%
Distribution Rate3 6.11%
30-Day Standardized Yield4 6.09%
</TABLE>
1. Cumulative total return represents the change in value of an investment over
the periods indicated and does not include the sales charge.
2. Average annual total return represents the average annual change in value of
an investment over the periods indicated and includes the current, maximum 4.25%
initial sales charge. Prior to July 1, 1994, fund shares were offered at a
higher initial sales charge. Thus actual total returns would be lower.
3. Distribution rate is based on an annualization of the current 5.3196 cent per
share monthly dividend and the maximum offering price of $10.59 on September 30,
1998.
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, 1998.
All total return calculations assume reinvestment of dividends and capital gains
at net asset value. The fund's manager agreed in advance to waive a portion of
its management fees, which reduces operating expenses and increases distribution
rate, yield and total return to shareholders. Without this waiver, the fund's
distribution rate and total return would have been lower, and yield for the
period would have been 5.29%. The fee waiver may be discontinued at any time
upon notice to the fund's Board of Trustees. Since markets can go down as well
as up, 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.
<TABLE>
<CAPTION>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Highlights
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------
1998 1997 1996 1995 1994
-------------------------------------------------------
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
<S> <C> <C> <C> <C> <C>
Net asset value, beginning of year $ 9.96 $9.74 $9.91 $9.42 $10.24
-------------------------------------------------------
Income from investment operations:
Net investment income .660 .708 .717 .714 .553
Net realized and unrealized gains (losses) .179 .220 (.170) .490 (.711)
-------------------------------------------------------
Total from investment operations .839 .928 .547 1.204 (.158)
-------------------------------------------------------
Less distributions from:
Net investment income (.659) (.708) (.717) (.714) (.553)
Net realized gains -- -- -- -- (.109)
-------------------------------------------------------
Total distributions (.659) (.708) (.717) (.714) (.662)
-------------------------------------------------------
Net asset value, end of year $10.14 $9.96 $9.74 $9.91 $ 9.42
=======================================================
Total return+ 8.71% 9.84% 5.69% 13.27% (1.61)%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of year (000's) $14,551 $8,934 $6,847 $5,980 $5,223
Ratios to average net assets:
Expenses --% --% --% --% --%
Expenses excluding waiver and payments by affiliate .74% .82% 1.11% 1.24% 1.28%
Net investment income 6.56% 7.18% 7.26% 7.42% 5.65%
Portfolio turnover rate* 38.15% 13.59% 17.64% 34.20% 86.38%
</TABLE>
+Total return does not reflect sales commissions and is not annualized.
*The portfolio turnover rate excludes mortgage dollar roll transactions.
See notes to financial statements.
<TABLE>
<CAPTION>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Statement of Investments, September 30, 1998
PRINCIPAL
AMOUNT VALUE
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
bMortgage-Backed Securities 70.0%
Federal Home Loan Mortgage Corp. (FHLMC) 19.7%
9.00%, 6/01/01 $ 37,353 $ 38,272
6.50%, 11/01/01 132,158 134,085
6.50%, 3/01/09 86,925 88,949
7.00%, 6/01/09 54,957 56,513
8.00%, 1/01/10 26,994 27,905
7.50%, 4/01/10 44,931 46,418
6.00%, 7/01/10 99,247 100,599
6.50%, 4/01/11 53,431 54,647
7.00%, 7/01/11 75,350 77,515
6.00%, 5/01/13 244,640 247,516
9.50%, 12/01/22 61,500 66,429
7.00%, 6/01/24 124,524 128,071
7.50%, 7/01/24 85,722 88,461
8.00%, 7/01/24 71,560 74,005
8.50%, 12/01/24 134,827 140,589
8.00%, 6/01/25 21,375 22,100
7.00%, 9/01/25 61,844 63,600
7.00%, 10/01/25 35,391 36,397
7.50%, 10/01/25 32,527 33,565
7.50%, 1/01/26 50,456 52,066
8.00%, 1/01/26 51,945 53,706
7.00%, 3/01/26 144,657 148,778
7.50%, 5/01/26 25,856 26,681
7.50%, 1/01/27 47,885 49,413
7.00%, 4/01/28 480,552 493,721
7.00%, 5/01/28 505,218 519,611
-----------
Total Federal Home Loan Mortgage Corp. (Cost $2,779,116) 2,869,612
-----------
Federal National Mortgage Association (FNMA) 37.8%
6.00%, 3/01/01 186,645 188,336
5.75%, 6/15/05 1,800,000 1,886,547
6.50%, 9/01/08 87,882 89,793
7.00%, 7/01/09 76,678 78,792
7.50%, 7/01/09 42,490 43,848
6.00%, 4/01/11 39,001 39,454
6.50%, 4/01/11 39,908 40,796
6.00%, 5/01/11 42,992 43,492
7.00%, 11/01/11 27,253 28,022
7.37%, 11/01/23 140,526 144,807
6.00%, 12/01/23 22,654 22,664
6.50%, 6/01/24 383,760 391,107
7.00%, 6/01/24 270,757 278,900
8.50%, 7/01/24 23,144 24,169
8.00%, 1/01/25 97,950 101,830
9.00%, 1/01/25 84,342 89,141
7.50%, 8/01/25 145,793 150,583
7.50%, 11/01/25 41,685 43,055
Federal National Mortgage Association (FNMA) (cont.)
8.00%, 12/01/25 $ 203,872 $ 211,925
7.00%, 1/01/26 53,568 55,182
7.50%, 3/01/26 33,913 35,021
7.00%, 6/01/26 62,586 64,467
8.00%, 6/01/26 12,340 12,827
8.00%, 7/01/26 26,340 27,380
8.00%, 8/01/26 49,267 51,211
7.50%, 10/01/26 60,438 62,411
7.00%, 4/01/27 269,800 277,546
6.50%, 3/01/28 1,004,222 1,022,305
-----------
Total Federal National Mortgage Association (Cost $5,251,333) 5,505,611
-----------
Government National Mortgage Association (GNMA), SF, 12.5%
9.00%, 12/15/16 82,652 89,157
10.00%, 10/15/18 44,103 48,626
9.50%, 10/15/20 76,581 83,034
8.00%, 2/15/23 145,074 152,023
7.00%, 6/15/23 210,079 217,648
7.50%, 6/15/23 100,366 104,319
6.50%, 1/15/24 219,677 225,622
8.50%, 7/15/24 75,833 80,872
8.00%, 1/15/25 25,573 26,782
7.50%, 9/15/25 57,359 59,552
7.00%, 1/15/26 43,528 45,015
7.50%, 1/15/26 63,214 65,619
7.00%, 3/15/26 20,397 21,094
7.50%, 5/15/26 18,071 18,758
8.00%, 6/15/26 52,336 54,809
8.50%, 8/15/26 11,212 11,992
8.00%, 8/20/26 20,560 21,371
7.50%, 10/15/26 33,930 35,221
7.50%, 9/15/27 445,282 461,912
-----------
Total Government National Mortgage Association (Cost $1,761,468) 1,823,426
-----------
Total Mortgage-Backed Securities (Cost $9,791,917) 10,198,649
-----------
U.S. Government Securities 3.6%
U.S. Treasury Notes, 5.625%, 12/31/02 500,000 524,376
-----------
Total U.S. Government Securities (Cost $506,719) 524,376
-----------
Total Long-Term Investments (Cost $10,298,636) 10,723,025
-----------
aRepurchase Agreement 25.4%
Joint Repurchase Agreement, 5.275%, 10/01/98 (Maturity Value $3,689,660)
(Cost $3,689,120) $3,689,120 $ 3,689,120
BankAmerica Securities, Inc. (Maturity Value $371,769)
Barclays Capital Group, Inc. (Maturity Value $343,739)
BT Alex Brown, Inc. (Maturity Value $371,769)
Chase Securities, Inc. (Maturity Value $371,769)
CIBC Wood Gundy Securities Corp. (Maturity Value $371,769)
Donaldson, Lufkin & Jenrette Securities Corp. (Maturity Value $371,769)
Dresdner Kleinwort Benson North America, L.L.C. (Maturity Value $371,769)
Greenwich Capital Markets, Inc. (Maturity Value $371,769)
Paribas Corp. (Maturity Value $371,769)
SBC Warburg Dillon Read, Inc. (Maturity Value $371,769)
Collateralized by U.S. Treasury Bills & Notes -----------
Total Investments (Cost $13,987,756) 99.0% 14,412,145
Other Assets, less Liabilities 1.0% 138,672
-----------
Net Assets 100.0% $14,550,817
-----------
aSee Note 1(b) regarding joint repurchase agreement.
</TABLE>
<TABLE>
<CAPTION>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements
Statement of Assets and Liabilities
September 30, 1998
Assets:
<S> <C>
Investments in securities, at value (cost $10,298,636) $10,723,025
Repurchase agreements, at value and cost 3,689,120
Cash 27,101
Receivables:
Capital shares sold 25,216
Interest 88,537
----------
Total assets 14,552,999
----------
Liabilities:
Payables:
Capital shares redeemed 2,020
Shareholders 162
----------
Total liabilities 2,182
----------
Net assets, at value $14,550,817
----------
Net assets consist of:
Net unrealized appreciation $ 424,389
Accumulated net realized loss (155,583)
Capital shares 14,282,011
----------
Net assets, at value $14,550,817
----------
Net asset value per share ($14,550,817 / 1,435,175 shares outstanding)* $10.14
==========
Maximum offering price per share ($10.14 / 95.75%) $10.59
==========
*Redemption price is equal to net asset value less any applicable sales charge.
See notes to financial statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS
for the year ended September 30, 1998
<S> <C> <C>
Investment income:
Interest $ 777,125
Expenses:
Management fees (Note 3) 47,370
Transfer agent fees (Note 3) 4,277
Custodian fees 64
Reports to shareholders 4,167
Registration and filing fees 18,535
Professional fees 12,959
Other 425
--------
Total expenses 87,797
----------
Expenses waived/paid by affiliate (Note 3) (87,797)
----------
Net expenses --
----------
Net investment income 777,125
----------
Realized and unrealized gains:
Net realized gain from investments 16,849
Net unrealized appreciation on investments 209,877
----------
Net realized and unrealized gain 226,726
----------
Net increase in net assets resulting from operations $1,003,851
==========
See notes to financial statements.
</TABLE>
<TABLE>
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
for the years ended September 30, 1998 and 1997
1998 1997
---------------------------------
Increase in net assets:
Operations:
<S> <C> <C>
Net investment income $ 777,125 $ 540,924
Net realized gain from investments 16,849 1,854
Net unrealized appreciation on investments 209,877 166,546
---------------------------------
Net increase in net assets resulting from operations 1,003,851 709,324
Distributions to shareholders from net investment income (775,976) (539,448)
Capital share transactions (Note 2) 5,388,997 1,916,844
---------------------------------
Net increase in net assets 5,616,872 2,086,720
Net assets (there was no undistributed net investment income at beginning and end of year):
Beginning of year 8,933,945 6,847,225
---------------------------------
End of year $14,550,817 $8,933,945
=================================
See notes to financial statements.
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Franklin Strategic Mortgage Portfolio (the Trust) is registered under the
Investment Company Act of 1940 as an open-end, diversified investment company.
The Trust consists of one Fund, the Franklin Strategic Mortgage Portfolio (the
Fund), which seeks total return. The following summarizes the Fund's significant
accounting policies.
a. Security Valuation:
Securities listed or traded on a recognized national exchange or NASDAQ are
valued at the latest reported sales price. Over-the-counter securities and
listed securities for which no sale is reported are valued within the range of
the latest quoted bid and asked prices. Securities for which market quotations
are not readily available are valued at fair value as determined by management
in accordance with procedures established by the Board of Trustees.
b. Joint Repurchase Agreement:
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. 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 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 Funds, with the value of the
underlying securities marked to market daily to maintain coverage of at least
100%. At September 30, 1998, all outstanding repurchase agreements had been
entered into on that date.
c. Income Taxes:
No provision has been made for income taxes because the Fund's policy is to
qualify as a regulated investment company under the Internal Revenue Code and to
distribute all of its taxable income.
d. Security Transactions, Investment Income, Expenses and Distributions:
Security transactions are accounted for on trade date. Realized gains and losses
on security transactions are determined on a specific identification basis.
Interest income and estimated expenses are accrued daily. Dividends from net
investment income are normally declared daily and distributed monthly to
shareholders.
e. Accounting Estimates:
The preparation of 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.
<TABLE>
<CAPTION>
2. SHARES OF BENEFICIAL INTEREST
At September 30, 1998, there were an unlimited number of shares authorized
($0.01 par value). Transactions in the Fund's shares were as follows:
Year Ended September 30,
------------------------------------------------------------
1998 1997
------------------------------------------------------------
Shares Amount Shares Amount
------------------------------------------------------------
<S> <C> <C> <C> <C>
Shares sold 736,173 $ 7,369,970 163,167 $1,611,537
Shares issued in reinvestment of distributions 67,712 678,453 52,806 521,075
Shares redeemed (265,706) (2,659,426) (21,862) (215,768)
------------------------------------------------------------
Net increase 538,179 $ 5,388,997 194,111 $1,916,844
============================================================
</TABLE>
3. TRANSACTIONS WITH AFFILIATES
Certain officers and trustees of the Fund are also officers or trustees of
Franklin Advisers, Inc. (Advisers), Franklin/Templeton Distributors, Inc.
(Distributors), Franklin Templeton Services, Inc. (FT Services) and
Franklin/Templeton Investor Services, Inc. (Investor Services), the Fund's
investment advisor, principal underwriter, administrative manager, and transfer
agent, respectively.
The Fund pays an investment management fee to Advisers based on the average 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% In excess of $500 million
Under an agreement with Advisers, FT Services provides administrative services
to the Fund. The fee is paid by Advisers based on average daily net assets, and
is not an additional expense of the Fund.
Advisers agreed in advance to waive management fees and assume payment of other
expenses as noted in the Statement of Operations.
Distributors received net commissions from sales of Fund shares for the year of
$5,058.
At September 30, 1998, Franklin Resources owned 48.47% of the Fund.
4. INCOME TAXES
At September 30, 1998, the Fund had tax basis capital losses of $144,687 which
may be carried over to offset future capital gains. Such losses expire as
follows:
Capital loss carryovers expiring in:
2002................................................ $ 90,251
2004................................................ 54,436
----------
$144,687
==========
At September 30, 1998, the net unrealized appreciation based on the cost of
investments for income tax purposes of $13,998,652 was as follows:
Unrealized appreciation.............................. $414,535
Unrealized depreciation.............................. (1,042)
----------
Net unrealized appreciation.......................... $413,493
==========
Net realized capital gains and losses differ for financial statement and tax
purposes primarily due to differing treatments of mortgage dollar roll
transactions.
5. INVESTMENT TRANSACTIONS
Purchases and sales of securities (excluding short-term securities) for the year
ended September 30, 1998 aggregated $6,900,654 and $3,804,773, respectively.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Independent Auditors' Report
To the Shareholders and
Board of Trustees of
Franklin Strategic Mortgage Portfolio:
In our opinion, the accompanying statement of assets and liabilities, including
the statement of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of Franklin Strategic Mortgage
Portfolio (the "Fund") at September 30, 1998, 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. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits, which included confirmation of securities at
September 30, 1998 by correspondence with the custodian, provide a reasonable
basis for the opinion expressed above.
PricewaterhouseCoopers LLP
San Francisco, California
October 30, 1998
Franklin Strategic Mortgage Portfolio
Annual Report
September 30, 1998.
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 investment holdings of the Franklin Strategic
Mortgage Portfolio based on total net assets as of 9/30/98.
30-Year Mortgage Pass-Throughs 46.34%
U.S. Treasury Note 16.57%
15-Year Mortgage Pass-Throughs 7.58%
Balloon Mortgage Pass-Throughs 2.21%
Adjustable Rate Mortgage 0.99%
Cash & Equivalents 26.31%
GRAPHIC MATERIAL (2)
This chart compares the performance of Franklin Strategic Mortgage Portfolio to
the Salomon Brothers Mortgage-Backed Securities Index from (2/1/93 - 9/30/98)
Franklin Strategic Salomon Brothers
Mortgage Portfolio Mortgage-Backed
Securities Index
- --------------------------------------------------------
2/1/93 $9,579 $10,000
2/28/93 $9,718 0.92% $10,092
3/31/93 $9,780 0.60% $10,153
4/30/93 $9,839 0.68% $10,222
5/31/93 $9,859 0.46% $10,269
6/30/93 $10,008 0.97% $10,368
7/31/93 $10,014 0.41% $10,411
8/31/93 $10,130 0.41% $10,453
9/30/93 $10,166 0.09% $10,463
10/31/93 $10,215 0.33% $10,497
11/30/93 $10,133 -0.18% $10,478
12/31/93 $10,230 0.75% $10,557
1/31/94 $10,349 1.01% $10,664
2/28/94 $10,187 -0.62% $10,598
3/31/94 $9,984 -2.47% $10,336
4/30/94 $9,932 -0.63% $10,271
5/31/94 $9,959 0.34% $10,306
6/30/94 $9,925 -0.25% $10,280
7/31/94 $10,109 1.95% $10,480
8/31/94 $10,139 0.21% $10,502
9/30/94 $10,002 -1.34% $10,362
10/31/94 $9,978 -0.03% $10,358
11/30/94 $9,952 -0.36% $10,321
12/31/94 $10,043 0.83% $10,407
1/31/95 $10,248 2.24% $10,640
2/28/95 $10,511 2.55% $10,911
3/31/95 $10,546 0.41% $10,956
4/30/95 $10,685 1.34% $11,103
5/31/95 $11,033 3.24% $11,463
6/30/95 $11,101 0.53% $11,523
7/31/95 $11,116 0.20% $11,546
8/31/95 $11,228 0.92% $11,653
9/30/95 $11,329 0.89% $11,756
10/31/95 $11,446 0.92% $11,864
11/30/95 $11,571 1.17% $12,003
12/31/95 $11,706 1.24% $12,152
1/31/96 $11,803 0.77% $12,246
2/29/96 $11,709 -0.79% $12,149
3/31/96 $11,658 -0.34% $12,108
4/30/96 $11,628 -0.46% $12,052
5/31/96 $11,591 -0.13% $12,036
6/30/96 $11,727 1.28% $12,190
7/31/96 $11,782 0.40% $12,239
8/31/96 $11,778 0.02% $12,242
9/30/96 $11,974 1.68% $12,447
10/31/96 $12,206 1.94% $12,689
11/30/96 $12,377 1.38% $12,864
12/31/96 $12,329 -0.44% $12,807
1/31/97 $12,414 0.85% $12,916
2/28/97 $12,437 0.11% $12,930
3/31/97 $12,392 -0.83% $12,823
4/30/97 $12,569 1.52% $13,018
5/31/97 $12,679 0.93% $13,139
6/30/97 $12,807 1.15% $13,290
7/31/97 $13,012 1.85% $13,536
8/31/97 $13,003 -0.18% $13,511
9/30/97 $13,152 1.19% $13,672
10/31/97 $13,280 1.08% $13,820
11/30/97 $13,312 0.34% $13,867
12/31/97 $13,436 0.91% $13,993
1/31/98 $13,563 0.93% $14,123
2/28/98 $13,594 0.30% $14,166
3/31/98 $13,643 0.39% $14,221
4/30/98 $13,712 0.56% $14,300
5/31/98 $13,809 0.70% $14,401
6/30/98 $13,889 0.44% $14,464
7/31/98 $13,951 0.49% $14,535
8/31/98 $14,096 0.91% $14,667
9/30/98 $14,297 1.20% $14,843
Total 42.97% 48.43%
Return
