SHAREHOLDER LETTER
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)
Dear Shareholder:
It's a pleasure to bring you the Franklin Strategic Mortgage Portfolio
semiannual report for the period ended March 31, 1999.
ECONOMIC OVERVIEW
The U.S. economy grew at a rapid pace during the reporting period, helped along
by Federal Reserve Board (the Fed) interest-rate cuts. Many investors responded
to October's worldwide financial market volatility by seeking out the safety and
liquidity of U.S. Treasury securities. Conditions such as the Russian debt
default, a major U.S. hedge fund's difficulties and the ongoing Asian
CONTENTS
Shareholder Letter ............... 1
Performance Summary .............. 5
Financial Highlights &
Statement of Investments ......... 6
Financial Statements ............. 10
Notes to
Financial Statements ............. 13
FUND CATEGORY
[GRAPHIC OMITTED]
(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.
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 7 of
this report.
Page
financial crisis shook global and domestic markets. The combination of fragile
international financial markets and reduced capital availability in the U.S
prompted the Fed's monetary policy panel, the Federal Open Market Committee, to
cut the federal funds target rate twice by 0.25%, to 4.75%, in an effort to
stimulate growth. The Fed's moves attempted to provide liquidity to the
financial system and make it easier for major corporations to obtain favorable
lending from banks. The U.S. economy responded by forging ahead, as shown by the
6.0% annualized rate for fourth quarter 1998 gross domestic product (GDP)
growth. Unemployment and inflation remained near historical lows during the
reporting period. In fact, calendar year inflation, as measured by the Consumer
Price Index (CPI), registered a mere 1.6% for all of 1998, a 12-year low.
Near the end of fourth quarter 1998, it became apparent that the economy was
growing more rapidly than generally anticipated, and yields on U.S. Treasury
securities began to rise in response. By mid-February, concerns mounted that
tight labor markets and strong consumer demand might lead the Fed to increase
interest rates to prevent inflationary pressures from developing. This sent
Treasury yields higher still, and the 30-year bond reached a seven-month high of
5.69% on March 4, 1999.
2
Page
PORTFOLIO NOTES
The rise in interest rates, while unfavorable for U.S. Treasury security
holders, was positive for some mortgage pass-through securities. The prevailing
mortgage rates rose with Treasury yields, reducing the incentive for homeowners
to refinance their mortgages. According to the Federal Home Loan Mortgage
Corporation, the conforming 30-year fixed mortgage rate rose from 6.60% on
October 1, 1998, to 6.98% as of month-end March 1999. These higher rates
somewhat decreased prepayment risk. Higher-coupon pass-throughs, which are
subject to more prepayment risk in a declining interest-rate environment,
delivered superior returns. In contrast, lower-coupon pass-throughs, which are
less sensitive to prepayments than higher-coupon issues, did not benefit from
the rise in rates.
PORTFOLIO BREAKDOWN
Based on Total Net Assets
3/31/99 9/30/98
- ---------------------------------------------------------------------
30-Year Mortgage Pass-Throughs 73.59% 46.34%
U.S. Treasury Notes/Agency Debentures 8.03% 16.57%
Adjustable Rate Mortgage 2.87% 0.99%
15-Year Mortgage Pass-Throughs 2.65% 7.58%
Balloon Mortgage Pass-Throughs 1.35% 2.21%
Cash & Equivalents 11.51% 26.31%
DIVIDEND DISTRIBUTIONS*
10/1/98 - 3/31/99
DIVIDEND
MONTH PER SHARE
- ------------------------------
October 5.1792 cents
November 5.2414 cents
December 5.4427 cents
January 4.9055 cents
February 5.0122 cents
March 5.7104 cents
TOTAL 31.4914 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.
3
Page
Q: WHAT IS A BALLOON MORTGAGE PASS-THROUGH?
A: A balloon mortgage pass-through denotes a mortgage whose final payment is
substantially larger than the preceding payments. Mortgages are structured with
balloon payments when some projected event is expected to provide extra cash
flow or when refinancing is anticipated.*
*Source: Barron's Dictionary of Finance and Investment Terms, 1995.
During the reporting period, the fund reduced its exposure to balloon mortgage
pass-throughs, from 2.21% to 1.35% of total net assets, and 15-year mortgage
pass-throughs, from 7.58% to 2.65%. We took advantage of relative value
opportunities to add to our 30-year pass-through positions, particularly
lower-coupon Federal National Mortgage Association (FNMA) pass-throughs and
higher-coupon Government National Mortgage Association (GNMA) pass-throughs. The
fund also reduced its exposure to U.S. Treasury securities in favor of the
higher yields offered by mortgage pass-throughs.
In the near term, we do not expect interest rates to rise significantly higher.
We will look to increase our allocation to mortgage securities as relative value
opportunities arise.
Please remember, this discussion reflects our views, opinions and portfolio
holdings as of March 31, 1999, 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.
Sincerely,
/s/ Roger Bayston
Roger Bayston
Portfolio Manager
Franklin Strategic Mortgage Portfolio
4
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CLASS A (formerly Class I):
Subject to 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. The fund's manager agreed in advance to waive a
portion of its management fees, which reduces operating expenses and increases
yield, total return and distribution rate to shareholders. Without this waiver,
the fund's total return and distribution rate would have been lower, and yield
for the period would have been 5.38%. The fee waiver may be discontinued at any
time upon notice to the fund's Board of Trustees.
1. Cumulative total return represents the change in value of an investment over
the periods indicated and does not include sales charges.
2. Average annual total return represents the average annual change in value of
an investment over the periods indicated and includes the current, applicable,
maximum sales charge for that class. Six-month return has not been annualized.
3. Distribution rate is based on an annualization of the current 5.7104 cent per
share monthly dividend and the maximum offering price of $10.44 on March 31,
1999.
4. Yield, calculated as required by the SEC, is based on the earnings of the
fund's portfolio for the 30 days ended March 31, 1999.
Since markets can go down as well as up, investment return and principal value
will fluctuate with market conditions, and you may have a gain or loss when you
sell your shares.
PERFORMANCE SUMMARY AS OF 3/31/99
Distributions will vary based on earnings of the fund's portfolio and any
profits realized from the sale of the portfolio's securities. Past distributions
are not indicative of future trends. All total returns include reinvested
distributions at net asset value.
PRICE AND DISTRIBUTION INFORMATION (10/1/98-3/31/99)
<TABLE>
<CAPTION>
CLASS A CHANGE 3/31/99 9/30/98
- ------------------------------------------------------------------------------
<S> <C> <C> <C>
Net Asset Value -$0.14 $10.00 $10.14
DISTRIBUTIONS
- ------------------------------------------------------------------------------
Dividend Income $0.3149141
</TABLE>
PERFORMANCE
<TABLE>
<CAPTION>
INCEPTION
CLASS A 6-MONTH 1-YEAR 5-YEAR (2/1/93)
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Cumulative Total Return(1) +1.75% +6.63% +45.70% +51.88%
Average Annual Total Return(2) -2.58% +2.13% +6.89% +6.28%
Distribution Rate(3) 6.00%
30-Day Standardized Yield(4) 6.03%
</TABLE>
Past performance is not predictive of future results.
5
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Highlights
<TABLE>
<CAPTION>
SIX MONTHS ENDED YEAR ENDED SEPTEMBER 30,
MARCH 31, 1999 --------------------------------------------------------
(UNAUDITED) 1998 1997 1996 1995 1994
------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the
period)
Net asset value, beginning of period ...... $ 10.14 $ 9.96 $ 9.74 $ 9.91 $ 9.42 $10.24
------------------------------------------------------------------------------
Income from investment operations:
Net investment income .................... .316 .660 .708 .717 .714 .553
Net realized and unrealized gains
(losses) ............................... (.141) .179 .220 (.170) .490 (.711)
------------------------------------------------------------------------------
Total from investment operations .......... .175 .839 .928 .547 1.204 (.158)
------------------------------------------------------------------------------
Less distributions from:
Net investment income .................... (.315) (.659) (.708) (.717) (.714) (.553)
Net realized gains ....................... -- -- -- -- -- (.109)
------------------------------------------------------------------------------
Total distributions ....................... (.315) (.659) (.708) (.717) (.714) (.662)
------------------------------------------------------------------------------
Net asset value, end of period ............ $ 10.00 $ 10.14 $ 9.96 $ 9.74 $ 9.91 $ 9.42
==============================================================================
Total return+ ............................. 1.75% 8.71% 9.84% 5.69% 13.27% (1.61)%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period (000's) ......... $20,883 $14,551 $8,934 $6,847 $5,980 $5,223
Ratios to average net assets:
Expenses ................................. --% --% --% --% --% --%
Expenses excluding waiver and payments by
affiliate .............................. .70%* .74% .82% 1.11% 1.24% 1.28%
Net investment income .................... 6.28%* 6.56% 7.18% 7.26% 7.42% 5.65%
Portfolio turnover rate** ................. 22.86% 38.15% 13.59% 17.64% 34.20% 86.38%
</TABLE>
+ Total return does not reflect sales commissions and is not annualized for
periods less than one year.
* Annualized
** The portfolio turnover rate excludes mortgage dollar roll transactions.
See notes to financial statements.
6
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, MARCH 31, 1999 (UNAUDITED)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C>
MORTGAGE-BACKED SECURITIES 85.3%
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) 10.4%
9.00%, 6/01/01 ............................................................... $ 25,674 $ 26,292
6.50%, 11/01/01 .............................................................. 95,656 97,197
6.50%, 3/01/09 ............................................................... 75,340 76,445
7.00%, 6/01/09 ............................................................... 47,898 49,144
8.00%, 1/01/10 ............................................................... 19,976 20,691
7.50%, 4/01/10 ............................................................... 36,252 37,512
6.50%, 4/01/11 ............................................................... 40,632 41,170
7.00%, 7/01/11 ............................................................... 63,762 65,431
9.50%, 12/01/22 .............................................................. 49,297 53,051
7.00%, 6/01/24 ............................................................... 107,791 109,828
7.50%, 7/01/24 ............................................................... 76,126 78,253
8.00%, 7/01/24 ............................................................... 50,500 52,663
8.50%, 12/01/24 .............................................................. 133,792 140,999
8.00%, 6/01/25 ............................................................... 12,924 13,471
7.00%, 9/01/25 ............................................................... 54,595 55,619
7.00%, 10/01/25 .............................................................. 22,944 23,374
7.50%, 10/01/25 .............................................................. 27,194 27,946
7.50%, 1/01/26 ............................................................... 38,708 39,777
8.00%, 1/01/26 ............................................................... 40,947 42,680
7.00%, 3/01/26 ............................................................... 116,944 119,108
7.50%, 5/01/26 ............................................................... 22,408 23,017
7.50%, 1/01/27 ............................................................... 35,726 36,696
7.00%, 4/01/28 ............................................................... 474,015 481,878
7.00%, 5/01/28 ............................................................... 446,397 454,657
----------
TOTAL FEDERAL HOME LOAN MORTGAGE CORP. (COST $2,110,731) ..................... 2,166,899
----------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) 50.8%
6.00%, 3/01/01 ............................................................... 184,586 185,249
5.75%, 6/15/05 ............................................................... 1,000,000 1,004,487
6.50%, 9/01/08 ............................................................... 76,712 77,762
7.00%, 7/01/09 ............................................................... 67,544 69,219
7.50%, 7/01/09 ............................................................... 29,221 30,220
6.50%, 4/01/11 ............................................................... 36,059 36,466
7.00%, 11/01/11 .............................................................. 22,287 22,821
6.678%, 4/01/18 .............................................................. 484,897 500,796
7.395%, 11/01/23 ............................................................. 96,274 98,456
6.00%, 12/01/23 .............................................................. 21,473 20,923
6.50%, 6/01/24 ............................................................... 365,924 365,251
7.00%, 6/01/24 ............................................................... 174,077 176,932
8.50%, 7/01/24 ............................................................... 17,387 18,301
8.00%, 1/01/25 ............................................................... 69,230 72,075
9.00%, 1/01/25 ............................................................... 63,204 67,369
7.50%, 8/01/25 ............................................................... 105,572 108,694
7.50%, 11/01/25 .............................................................. 20,019 20,612
8.00%, 12/01/25 .............................................................. 151,825 158,055
7.00%, 1/01/26 ............................................................... 45,467 46,203
7.50%, 3/01/26 ............................................................... 31,426 32,349
</TABLE>
7
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, MARCH 31, 1999 (UNAUDITED) (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C>
MORTGAGE-BACKED SECURITIES (CONT.)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) (CONT.)
7.00%, 6/01/26 ............................................................. $ 52,523 $ 53,365
8.00%, 6/01/26 ............................................................. 7,574 7,885
7.50%, 7/01/26 ............................................................. 461,041 474,570
8.00%, 7/01/26 ............................................................. 14,976 15,590
8.00%, 8/01/26 ............................................................. 31,450 32,739
7.50%, 10/01/26............................................................. 40,394 41,580
7.00%, 4/01/27 ............................................................. 206,291 209,619
6.50%, 12/01/27............................................................. 1,803,898 1,798,464
6.00%, 3/01/28 ............................................................. 993,989 967,519
6.50%, 3/01/28 ............................................................. 950,946 947,899
7.00%, 10/01/28............................................................. 968,114 983,150
6.00%, 12/01/28............................................................. 999,999 973,369
6.00%, 3/01/29 ............................................................. 499,950 486,636
(b)6.50%, 4/01/29 ............................................................. 500,000 497,656
----------
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION (COST $10,500,960) ............. 10,602,281
----------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, 24.1%
9.00%, 12/15/16 ............................................................ 69,040 74,536
10.00%, 10/15/18............................................................ 41,488 45,822
9.50%, 10/15/20 ............................................................ 65,085 70,323
8.00%, 2/15/23 ............................................................. 117,917 123,203
7.00%, 6/15/23 ............................................................. 200,418 204,255
7.50%, 6/15/23 ............................................................. 45,638 47,115
6.50%, 1/15/24 ............................................................. 210,660 210,450
8.50%, 7/15/24 ............................................................. 53,930 57,168
8.00%, 1/15/25 ............................................................. 19,666 20,504
7.50%, 9/15/25 ............................................................. 54,643 56,365
7.00%, 1/15/26 ............................................................. 38,525 39,178
7.50%, 1/15/26 ............................................................. 51,633 53,236
7.00%, 3/15/26 ............................................................. 19,085 19,409
7.50%, 5/15/26 ............................................................. 17,980 18,538
8.00%, 6/15/26 ............................................................. 41,058 42,803
8.50%, 8/15/26 ............................................................. 7,728 8,178
8.00%, 8/20/26 ............................................................. 14,936 15,441
7.50%, 10/15/26............................................................. 30,193 31,131
8.00%, 7/15/27 ............................................................. 965,396 1,006,462
7.50%, 9/15/27 ............................................................. 651,613 671,737
7.00%, 12/15/27............................................................. 1,009,103 1,026,010
6.50%, 4/15/28 ............................................................. 504,470 502,884
7.50%, 5/15/28 ............................................................. 673,594 694,227
----------
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (COST $5,014,176) ........... 5,038,975
----------
TOTAL MORTGAGE-BACKED SECURITIES (COST $17,625,867) ........................ 17,808,155
----------
</TABLE>
8
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, MARCH 31, 1999 (UNAUDITED) (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C>
U.S. GOVERNMENT SECURITIES 3.2%
U.S. Treasury Notes, 8.875%, 2/15/19 (COST $684,063) ....................... $ 500,000 $ 672,344
-----------
TOTAL LONG TERM INVESTMENTS (COST $18,309,930) ............................. 18,480,499
-----------
(a)REPURCHASE AGREEMENT 11.5%
Joint Repurchase Agreement, 4.875%, 4/01/99 (Maturity Value $2,406,713)
(COST $2,406,387) .......................................................... 2,406,387 2,406,387
Barclays Capital Inc. (Maturity Value $308,238)
Bear, Stearns & Co. Inc. (Maturity Value $168,134)
Chase Securities Inc. (Maturity Value $80,913)
CIBC Oppenheimer Corp. (Maturity Value $308,238)
Donaldson, Lufkin & Jenrette Securities Corp. (Maturity Value $308,238)
Dresdner Kleinwort Benson, North America LLC (Maturity Value $308,238)
Lehman Brothers Inc. (Maturity Value $308,238)
Paribas Corp. (Maturity Value $308,238)
Warburg Dillon Read LLC (Maturity Value $308,238)
Collateralized by U.S. Treasury Bills & Notes
TOTAL INVESTMENTS (COST $20,716,317) 100.0% ................................ 20,886,886
OTHER ASSETS, LESS LIABILITIES ............................................. (3,471)
-----------
NET ASSETS 100.0% .......................................................... $20,883,415
===========
</TABLE>
(a) See Note 1(b) regarding joint repurchase agreement.
(b) Sufficient collateral has been segregated for securities traded on a when-
issued or delayed delivery basis.
See notes to financial statements.
9
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements
STATEMENT OF ASSETS AND LIABILITIES
MARCH 31, 1999 (UNAUDITED)
<TABLE>
<CAPTION>
Assets:
<S> <C>
Investments in securities:
Cost ........................................................................ $18,309,930
===========
Value ....................................................................... 18,480,499
Repurchase agreements, at value and cost ..................................... 2,406,387
Receivables:
Investment securities sold .................................................. 709
Capital shares sold ......................................................... 450,103
Interest .................................................................... 117,203
-----------
Total assets ............................................................ 21,454,901
-----------
Liabilities:
Payables:
Investment securities purchased ............................................. 499,220
Capital shares redeemed ..................................................... 10,100
Shareholders ................................................................ 1,866
Distributions to shareholders ................................................ 60,300
-----------
Total liabilities ....................................................... 571,486
-----------
Net assets, at value ................................................... $20,883,415
===========
Net assets consist of:
Net unrealized appreciation ................................................ $ 170,569
Accumulated net realized loss .............................................. (130,686)
Capital shares ............................................................. 20,843,532
-----------
Net assets, at value ................................................... $20,883,415
===========
Net asset value per share ($20,883,415 / 2,088,748 shares outstanding)* ...... $10.00
===========
Maximum offering price per share ($10.00 / 95.75%) ........................... $10.44
===========
</TABLE>
*Redemption price is equal to net asset value less any applicable sales charge.
See notes to financial statements.
10
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
STATEMENT OF OPERATIONS
FOR THE SIX MONTHS ENDED MARCH 31, 1999 (UNAUDITED)
<TABLE>
<CAPTION>
<S> <C>
Investment income:
Interest ..................................................................... $522,825
--------
Expenses:
Management fees (Note 3) ..................................................... 33,241
Transfer agent fees (Note 3) ................................................. 3,985
Custodian fees ............................................................... 45
Reports to shareholders ...................................................... 2,268
Registration and filing fees ................................................. 10,577
Professional fees ............................................................ 7,356
Other ........................................................................ 399
--------
Total expenses .......................................................... 57,871
Expenses waived/paid by affiliate (Note 3) .............................. (57,871)
--------
Net investment income .................................................. 522,825
--------
Realized and unrealized gains (losses):
Net realized gain from investments .......................................... 21,883
Net unrealized depreciation on investments .................................. (253,820)
--------
Net realized and unrealized loss .............................................. (231,937)
--------
Net increase in net assets resulting from operations .......................... $290,888
========
</TABLE>
See notes to financial statements.
11
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
STATEMENT OF CHANGES IN NET ASSETS
FOR THE SIX MONTHS ENDED MARCH 31, 1999 (UNAUDITED)
AND THE YEAR ENDED SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
SIX MONTHS ENDED YEAR ENDED
MARCH 31, 1999 SEPTEMBER 30,1998
-------------- -----------------
<S> <C> <C>
Increase (decrease) in net assets:
Operations:
Net investment income ....................................................... $ 522,825 $ 777,125
Net realized gain from investments .......................................... 21,883 16,849
Net unrealized appreciation (depreciation) on investments ................... (253,820) 209,877
----------------------------------
Net increase in net assets resulting from operations .................... 290,888 1,003,851
Distributions to shareholders from net investment income ..................... (519,811) (775,976)
Capital share transactions: (Note 2) ......................................... 6,561,521 5,388,997
----------------------------------
Net increase in net assets .............................................. 6,332,598 5,616,872
Net assets (there was no undistributed net investment income
at beginning and end of period):
Beginning of period .......................................................... 14,550,817 8,933,945
----------------------------------
End of period ................................................................ $20,883,415 $14,550,817
==================================
</TABLE>
See notes to financial statements.
12
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (unaudited)
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 is 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 March 31, 1999, 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 substantially 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.
13
Page
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (unaudited) (continued)
2. SHARES OF BENEFICIAL INTEREST
At March 31, 1999, there were an unlimited number of shares authorized ($0.01
par value). Transactions in the Fund's shares were as follows:
<TABLE>
<CAPTION>
SIX MONTHS YEAR ENDED
ENDED MARCH 31, 1999 SEPTEMBER 30, 1998
SHARES AMOUNT SHARES AMOUNT
------------------------------------------------------
<S> <C> <C> <C> <C>
Shares sold ........................................... 788,051 $7,911,851 736,173 $7,369,970
Shares issued in reinvestment of distributions ........ 25,070 252,212 67,712 678,453
Shares redeemed ....................................... (159,548) (1,602,542) (265,706) (2,659,426)
------------------------------------------------------
Net increase .......................................... 653,573 $6,561,521 538,179 $5,388,997
======================================================
</TABLE>
3. TRANSACTIONS WITH AFFILIATES
Certain officers and trustees of the Fund are also officers or directors 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:
<TABLE>
<CAPTION>
ANNUALIZED
FEE RATE AVERAGE DAILY NET ASSETS
----------------------------------------------------------------------
<S> <C>
.400% First $250 million
.380% Over $250 million, up to and including $500 million
.360% In excess of $500 million
</TABLE>
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 period
of $3,506.
At March 31, 1999, Franklin Resources, Inc. owned 33.47% of the Fund.
14
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (unaudited) (continued)
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:
<TABLE>
<CAPTION>
Capital loss carryovers expiring in:
<S> <C>
2002 ........................................ $ 90,251
2004 ........................................ 54,436
--------
$144,687
========
</TABLE>
At March 31, 1999, the net unrealized appreciation based on the cost of
investments for income tax purposes of $20,724,199 was as follows:
<TABLE>
<CAPTION>
<S> <C>
Unrealized appreciation .............. $203,277
Unrealized depreciation .............. (40,590)
---------
Net unrealized appreciation .......... $162,687
=========
</TABLE>
Distributions of income to shareholders may not equal net investment income due
to differing treatments of mortgage dollar roll transactions for book and tax
purposes.
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
period ended March 31, 1999 aggregated $11,266,108 and $3,286,138, respectively.
15
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