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:
This annual report for Franklin Strategic Mortgage Portfolio covers the period
ended September 30, 1999.
ECONOMIC OVERVIEW
The U.S. economy grew at a rapid pace during the year under review, stimulated
by the Federal Reserve Board (the Fed) interest rate cuts of fall 1998. Turmoil
engulfed financial markets around the world in early October 1998, causing many
investors to seek out the safety and liquidity of U.S. Treasury securities. This
caused the yield spreads, or the difference in yields between mortgage-backed
securities and Treasuries, to reach historically wide levels. The combination of
fragile international financial markets and reduced availability of capital
in the U.S. prompted the Fed to cut the federal funds target rate twice during
the reporting period, lowering it to 4.75% on November 17, 1998.
CONTENTS
Shareholder Letter ...................................................... 1
Performance Summary ..................................................... 5
Financial Highlights &
Statement of Investments ................................................ 7
Financial Statements .................................................... 11
Notes to
Financial Statements .................................................... 14
Independent
Auditors' Report ........................................................ 17
[PYRAMID GRAPHIC]
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 8 of
this report.
Near the end of 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. At the same time, many investors began to take advantage of
the wide yield spreads on mortgage-backed securities, resulting in narrowing
yield spreads during the first quarter of 1999. Throughout the first half of
1999, the market came to expect that tight labor markets and strong consumer
demand would lead the Fed to increase interest rates to dampen inflationary
pressures. The market was correct in this case, as the Fed raised the federal
funds target rate to 5.00% on June 30, 1999, and to 5.25% on August 24, 1999.
This sent Treasury yields temporarily higher, with the 30-year bond reaching a
period high of 6.28% on August 12, 1999.
PORTFOLIO BREAKDOWN
Based on Total Net Assets
9/30/99 9/30/98
- ----------------------------------------------------------------
30-Year Mortgage Pass-Throughs 78.45% 46.34%
15-Year Mortgage Pass-Throughs 15.78% 7.58%
Adjustable Rate Mortgage 3.79% 0.99%
Cash & Equivalents 1.26% 26.31%
Balloon Mortgage Pass-Throughs 0.72% 2.21%
U.S. Treasury Notes/Agency Debentures 0.00% 16.57%
PORTFOLIO NOTES
The rise in interest rates during this period was positive for some
mortgage-backed 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 2, 1998, to 7.76% on September
24, 1999. At these higher rates, prepayments slowed and prepayment risk
diminished. Therefore, higher-coupon pass-throughs performed well, as they are
subject to more prepayment risk in a declining interest-rate environment.
Yield spreads of mortgage-backed securities again became very attractive during
the summer of 1999. While interest rates rose during the summer, a large amount
of corporate bonds and asset-backed bonds came to market. This increased bond
supply offered yield advantages over Treasuries, negatively impacting these
bond's prices. Since yields rise when prices fall, the yield spread between
Treasuries and mortgage-backed securities widened substantially.
The fund took advantage of these attractive yield spreads to add to its
positions of 15-year and 30-year mortgage pass-throughs. In doing so, the fund
significantly reduced its exposure to Treasury and U.S. government agency bonds,
in favor of the higher yields offered by mortgage-backed securities. We
increased allocation to adjustable-rate mortgage-backed securities as well.
DIVIDEND DISTRIBUTIONS*
10/1/98 - 9/30/99
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
April 5.3432 cents
May 4.4105 cents
June 5.3847 cents
July 5.2970 cents
August 5.3234 cents
September 5.4532 cents
- -----------------------------
TOTAL 62.7034 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.
Over the near term, we believe that yield spreads of mortgage-backed securities
should return to more historical levels once the supply of competing products
has been absorbed and the market turns its attention away from year-end
liquidity concerns.
Please remember, this discussion reflects our views, opinions and portfolio
holdings as of September 30, 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
PERFORMANCE SUMMARY AS OF 9/30/99
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
CLASS A CHANGE 9/30/99 9/30/98
- ---------------------------------------------------------------
Net Asset Value -$0.40 $9.74 $10.14
DISTRIBUTIONS (10/1/98 - 9/30/99)
---------------------------------
Dividend Income $0.627034
PERFORMANCE
INCEPTION
CLASS A 1-YEAR 5-YEAR (2/1/93)
- --------------------------------------------------------------------------------
Cumulative Total Return(1) +2.30% +46.24% +52.71%
Average Annual Total Return(2) -2.04% +6.96% +5.87%
Distribution Rate(3) 6.52%
30-Day Standardized Yield(4) 6.51%
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 5.98%. 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 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, applicable,
maximum sales charge.
3. Distribution rate is based on an annualization of the current 5.4532 cent per
share monthly dividend and the maximum offering price of $10.17 on September 30,
1999.
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, 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.
Past performance is not predictive of future results.
TOTAL RETURN INDEX COMPARISON FOR HYPOTHETICAL $10,000 INVESTMENT
Total return represents the change in value of an investment over the periods
shown. It includes the current, applicable, maximum sales charge, fund expenses,
account fees and reinvested distributions. The unmanaged index differs from the
fund in composition, does not pay management fees or expenses and includes
reinvested dividends. One cannot invest directly in an index.
The following line graph compares the performance of the Franklin Strategic
Mortgage Portfolio Class A shares to that of the Salomon Brothers
Mortgage-Backed Securities Index based on a $10,000 investment from 2/1/93 -
9/30/99.
<TABLE>
<CAPTION>
Salomon Brothers Mortgage-
Franklin Strategic Mortgage Portfolio Backed Securities Index
-------------------------------------- --------------------------
<S> <C> <C> <C>
02/01/1993 $ 9,579 $10,000
02/28/1993 $ 9,718 0.92% $10,092
03/31/1993 $ 9,780 0.60% $10,153
04/30/1993 $ 9,839 0.68% $10,222
05/31/1993 $ 9,859 0.45% $10,268
06/30/1993 $10,008 0.96% $10,366
07/31/1993 $10,014 0.42% $10,410
08/31/1993 $10,130 0.42% $10,453
09/30/1993 $10,166 0.08% $10,462
10/31/1993 $10,215 0.34% $10,497
11/30/1993 $10,133 -0.18% $10,478
12/31/1993 $10,230 0.74% $10,556
01/31/1994 $10,349 1.01% $10,663
02/28/1994 $10,187 -0.63% $10,595
03/31/1994 $ 9,984 -2.46% $10,335
04/30/1994 $ 9,932 -0.63% $10,270
05/31/1994 $ 9,959 0.35% $10,306
06/30/1994 $ 9,925 -0.26% $10,279
07/31/1994 $10,109 1.95% $10,479
08/31/1994 $10,139 0.22% $10,502
09/30/1994 $10,002 -1.35% $10,361
10/31/1994 $ 9,978 -0.02% $10,358
11/30/1994 $ 9,952 -0.36% $10,321
12/31/1994 $10,043 0.83% $10,407
01/31/1995 $10,248 2.25% $10,641
02/28/1995 $10,511 2.55% $10,912
03/31/1995 $10,546 0.40% $10,956
04/30/1995 $10,685 1.33% $11,102
05/31/1995 $11,033 3.24% $11,461
06/30/1995 $11,101 0.53% $11,522
07/31/1995 $11,116 0.20% $11,545
08/31/1995 $11,228 0.92% $11,651
09/30/1995 $11,329 0.90% $11,756
10/31/1995 $11,446 -0.85% $11,656
11/30/1995 $11,571 2.98% $12,004
12/31/1995 $11,706 1.24% $12,153
01/31/1996 $11,803 0.77% $12,246
02/29/1996 $11,709 -0.79% $12,149
03/31/1996 $11,658 -0.34% $12,108
04/30/1996 $11,628 -0.46% $12,052
05/31/1996 $11,591 -0.13% $12,037
06/30/1996 $11,727 1.28% $12,191
07/31/1996 $11,782 0.40% $12,240
08/31/1996 $11,778 0.02% $12,242
09/30/1996 $11,974 1.68% $12,448
10/31/1996 $12,206 1.94% $12,689
11/30/1996 $12,377 1.38% $12,864
12/31/1996 $12,329 -0.44% $12,808
01/31/1997 $12,414 0.85% $12,917
02/28/1997 $12,437 0.11% $12,931
03/31/1997 $12,392 -0.83% $12,823
04/30/1997 $12,569 1.52% $13,018
05/31/1997 $12,679 0.93% $13,139
06/30/1997 $12,807 1.15% $13,290
07/31/1997 $13,012 1.85% $13,536
08/31/1997 $13,003 -0.18% $13,512
09/30/1997 $13,152 1.19% $13,673
10/31/1997 $13,280 1.08% $13,820
11/30/1997 $13,312 0.34% $13,867
12/31/1997 $13,436 0.91% $13,994
01/31/1998 $13,563 0.93% $14,124
02/28/1998 $13,594 0.30% $14,166
03/31/1998 $13,643 0.39% $14,221
04/30/1998 $13,712 0.56% $14,301
05/31/1998 $13,809 0.70% $14,401
06/30/1998 $13,889 0.44% $14,464
07/31/1998 $13,951 0.49% $14,535
08/31/1998 $14,096 0.91% $14,668
09/30/1998 $14,297 1.20% $14,844
10/31/1998 $14,300 -0.11% $14,827
11/30/1998 $14,388 0.46% $14,896
12/31/1998 $14,451 0.50% $14,970
01/31/1999 $14,536 0.69% $15,073
02/28/1999 $14,464 -0.37% $15,018
03/31/1999 $14,547 0.69% $15,121
04/30/1999 $14,610 0.49% $15,195
05/31/1999 $14,514 -0.67% $15,093
06/30/1999 $14,475 -0.23% $15,059
07/31/1999 $14,391 -0.68% $14,956
08/31/1999 $14,381 -0.06% $14,947
09/30/1999 $14,628 1.70% $15,201
</TABLE>
AVERAGE ANNUAL TOTAL RETURN
9/30/99
CLASS A
- --------------------------------
1-Year -2.04%
5-Year +6.96%
Since Inception (2/1/93) +5.87%
*Source: Standard and Poor's(R) Micropal.
Past performance is not predictive of future results.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Highlights
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------
1999 1998 1997 1996 1995
-------------------------------------------------------
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net asset value, beginning of year $ 10.14 $ 9.96 $ 9.74 $ 9.91 $ 9.42
-------------------------------------------------------
Income from investment operations:
Net investment income .627 .660 .708 .717 .714
Net realized and unrealized gains (losses) (.400) .179 .220 (.170) .490
-------------------------------------------------------
Total from investment operations .227 .839 .928 .547 1.204
-------------------------------------------------------
Less distributions from net investment income (.627) (.659) (.708) (.717) (.714)
-------------------------------------------------------
Net asset value, end of year $ 9.74 $ 10.14 $ 9.96 $ 9.74 $ 9.91
=======================================================
Total return* 2.30% 8.71% 9.84% 5.69% 13.27%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of year (000's) $32,877 $14,551 $8,934 $6,847 $5,980
Ratios to average net assets:
Expenses --% --% --% --% --%
Expenses excluding waiver and payments by affiliate .65% .74% .82% 1.11% 1.24%
Net investment income 6.32% 6.56% 7.18% 7.26% 7.42%
Portfolio turnover rate** 41.72% 38.15% 13.59% 17.64% 34.20%
</TABLE>
*Total return does not reflect sales commissions and is not annualized for
periods less than one year.
**The portfolio turnover rate excludes mortgage dollar roll transactions.
See notes to financial statements.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 1999
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- ----------------------------------------------------------------------------------------------------
<S> <C> <C>
MORTGAGE-BACKED SECURITIES 98.0%
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) 11.2%
9.00%, 6/01/01 ................................................ $ 20,225 $ 20,486
6.50%, 11/01/01 ............................................... 94,823 95,130
6.50%, 3/01/09 ................................................ 66,457 65,815
7.00%, 6/01/09 ................................................ 41,817 42,023
8.00%, 1/01/10 ................................................ 17,291 17,810
7.50%, 4/01/10 ................................................ 25,934 26,396
6.50%, 4/01/11 ................................................ 38,070 37,571
7.00%, 7/01/11 ................................................ 56,556 56,725
9.50%, 12/01/22 ............................................... 38,508 41,374
7.00%, 6/01/24 ................................................ 88,009 86,886
7.50%, 7/01/24 ................................................ 75,639 76,308
8.00%, 7/01/24 ................................................ 38,653 39,628
8.50%, 12/01/24 ............................................... 90,983 94,549
8.00%, 6/01/25 ................................................ 6,156 6,311
7.00%, 9/01/25 ................................................ 54,204 53,435
7.00%, 10/01/25 ............................................... 18,498 18,236
7.50%, 10/01/25 ............................................... 17,728 17,860
7.50%, 1/01/26 ................................................ 32,438 32,679
8.00%, 1/01/26 ................................................ 31,618 32,409
7.00%, 3/01/26 ................................................ 87,895 86,619
7.50%, 5/01/26 ................................................ 20,942 21,088
7.50%, 1/01/27 ................................................ 32,602 32,829
7.00%, 4/01/28 ................................................ 395,615 389,809
7.00%, 5/01/28 ................................................ 341,734 336,767
6.50%, 6/01/29 ................................................ 500,049 480,306
7.00%, 9/01/29 ................................................ 1,499,850 1,476,447
----------
TOTAL FEDERAL HOME LOAN MORTGAGE CORP. (COST $3,662,464) ...... 3,685,496
----------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) 57.4%
6.00%, 3/01/01 ................................................ 142,373 141,386
6.50%, 9/01/08 ................................................ 67,245 66,630
7.00%, 7/01/09 ................................................ 49,887 50,052
7.50%, 7/01/09 ................................................ 26,016 26,476
6.00%, 3/01/11 ................................................ 934,251 903,439
6.50%, 4/01/11 ................................................ 33,052 32,600
7.50%, 6/01/11 ................................................ 376,357 382,836
7.00%, 11/01/11 ............................................... 19,274 19,307
7.50%, 7/01/12 ................................................ 278,562 283,358
6.00%, 5/01/13 ................................................ 947,654 912,172
5.50%, 5/01/14 ................................................ 737,072 694,190
6.50%, 5/01/14 ................................................ 785,282 770,964
6.678%, 4/01/18 ............................................... 424,673 438,072
7.04%, 11/01/23 ............................................... 75,898 77,823
6.00%, 12/01/23 ............................................... 20,018 18,881
6.50%, 6/01/24 ................................................ 330,543 319,736
7.00%, 6/01/24 ................................................ 172,306 170,410
8.50%, 7/01/24 ................................................ 17,286 17,964
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 1999 (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- -----------------------------------------------------------------------------------------------------
<S> <C> <C>
MORTGAGE-BACKED SECURITIES (CONT.)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) (CONT.)
8.00%, 1/01/25 ................................................ $ 50,017 $ 51,125
9.00%, 1/01/25 ................................................ 49,146 51,628
7.50%, 8/01/25 ................................................ 88,047 88,535
7.50%, 11/01/25 ............................................... 17,544 17,642
8.00%, 12/01/25 ............................................... 121,055 123,727
7.00%, 1/01/26 ................................................ 38,817 38,310
7.00%, 6/01/26 ................................................ 46,859 46,168
8.00%, 6/01/26 ................................................ 4,809 4,914
8.00%, 7/01/26 ................................................ 10,650 10,883
8.00%, 8/01/26 ................................................ 23,371 23,882
7.50%, 10/01/26 ............................................... 27,580 27,708
7.00%, 4/01/27 ................................................ 167,644 165,119
6.50%, 12/01/27 ............................................... 1,703,277 1,637,888
6.00%, 3/01/28 ................................................ 942,313 879,682
6.50%, 3/01/28 ................................................ 923,326 886,557
7.00%, 10/01/28 ............................................... 789,117 776,742
6.00%, 12/01/28 ............................................... 983,156 917,810
6.00%, 2/01/29 ................................................ 990,808 924,953
6.00%, 3/01/29 ................................................ 494,506 461,639
6.00%, 4/01/29 ................................................ 497,174 463,872
6.50%, 4/01/29 ................................................ 1,488,563 1,428,860
6.50%, 8/01/29 ................................................ 998,938 958,875
7.50%, 9/01/29 ................................................ 1,599,498 1,606,237
(a)7.50%, 10/01/29 ............................................... 1,000,000 1,003,750
(a)6.50%, 10/01/29 ............................................... 1,000,000 960,313
----------
TOTAL FEDERAL NATIONAL MORTGAGE ASSOCIATION (COST $19,158,903). 18,883,115
----------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, 27.2%
7.00%, 4/15/14 ................................................ 739,808 740,844
9.00%, 12/15/16 ............................................... 68,013 71,855
10.00%, 10/15/18 .............................................. 32,403 35,403
9.50%, 10/15/20 ............................................... 50,003 53,737
8.00%, 2/15/23 ................................................ 100,605 103,290
7.00%, 6/15/23 ................................................ 185,284 183,117
7.50%, 6/15/23 ................................................ 42,406 42,745
6.50%, 1/15/24 ................................................ 186,077 179,705
8.50%, 7/15/24 ................................................ 42,258 44,049
8.00%, 1/15/25 ................................................ 14,801 15,165
7.50%, 9/15/25 ................................................ 48,568 48,840
7.00%, 1/15/26 ................................................ 34,922 34,329
7.50%, 1/15/26 ................................................ 42,556 42,783
7.00%, 3/15/26 ................................................ 17,757 17,455
7.50%, 5/15/26 ................................................ 14,318 14,395
8.00%, 6/15/26 ................................................ 34,341 35,174
8.50%, 8/15/26 ................................................ 4,268 4,448
8.00%, 8/20/26 ................................................ 11,808 12,035
7.50%, 10/15/26 ............................................... 27,473 27,620
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 1999 (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
- ----------------------------------------------------------------------------------------------------
<S> <C> <C>
MORTGAGE-BACKED SECURITIES (CONT.)
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, (CONT.)
8.00%, 7/15/27 ................................................. $ 839,148 $ 859,308
7.50%, 9/15/27 ................................................. 585,908 588,721
8.00%, 11/15/27 ................................................ 26,192 26,822
7.00%, 12/15/27 ................................................ 1,003,194 986,068
8.00%, 1/15/28 ................................................. 667,784 683,705
6.50%, 4/15/28 ................................................. 492,812 471,658
7.50%, 5/15/28 ................................................. 558,355 560,784
6.50%, 2/15/29 ................................................. 435,097 416,286
6.50%, 4/15/29 ................................................. 498,267 476,725
7.00%, 4/15/29 ................................................. 677,702 665,857
6.50%, 5/15/29 ................................................. 1,559,263 1,491,853
-----------
TOTAL GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (COST $9,146,806) 8,934,776
-----------
PRUDENTIAL HOME MORTGAGE SECURITIES (PHMS) 2.2%
7.186%, 7/25/18 (Cost $721,014) ................................ 722,820 721,014
-----------
TOTAL MORTGAGE-BACKED SECURITIES (COST $32,689,187) ............ 32,224,401
-----------
(b)REPURCHASE AGREEMENT 6.9%
Joint Repurchase Agreement, 5.217%, 10/01/99,
(Maturity Value $2,260,222) (COST $ 2,259,894) ............... 2,259,894 2,259,894
Banc of America Securities LLC
Barclays Capital Inc.
Bear, Stearns & Co. Inc.
Chase Securities Inc.
CIBC World Markets Corp.
Donaldson, Lufkin & Jenrette Securities Corp.
Dresdner Kleinwort Benson, North America LLC
Paine Webber Inc.
Paribas Corp.
Warburg Dillon Read LLC
Collateralized by U.S. Treasury Bills and Notes
-----------
TOTAL INVESTMENTS (COST $34,949,081) 104.9% .................... 34,484,295
-----------
OTHER ASSETS, LESS LIABILITIES (4.9%) .......................... (1,607,972)
-----------
NET ASSETS 100.0% .............................................. $ 32,876,323
===========
</TABLE>
(a) Sufficient collateral has been segregated for securities traded on a
when-issued or delayed delivery basis.
(b) Investment is through participation in a joint account with other funds
managed by the investment advisor. At September 30, 1999, all repurchase
agreements had been entered into on that date.
See notes to financial statements.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements
Statement of Assets and Liabilities
September 30, 1999
<TABLE>
Assets:
<S> <C>
Investments in securities, at value (cost $34,949,081) ............... $ 34,484,295
Receivables:
Capital shares sold ................................................. 372,772
Interest ............................................................ 181,082
------------
Total assets .................................................... 35,038,149
------------
Liabilities:
Payables:
Investment securities purchased ..................................... 1,973,181
Capital shares redeemed ............................................. 109,106
Shareholders ........................................................ 1,116
Distributions to shareholders ........................................ 78,423
------------
Total liabilities ............................................... 2,161,826
------------
Net assets, at value ........................................... $ 32,876,323
============
Net assets consist of:
Net unrealized depreciation .......................................... $ (464,786)
Accumulated net realized loss ........................................ (171,349)
Capital shares ....................................................... 33,512,458
------------
Net assets, at value ........................................... $ 32,876,323
============
Net asset value per share ($32,876,323 divided by 3,376,196
shares outstanding).................................................... $ 9.74
============
Maximum offering price per share ($9.74 divided by 95.75%) ........... $ 10.17
============
</TABLE>
See notes to financial statements.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
Statement of Operations
for the year ended September 30, 1999
Investment income:
Interest .......................................... $ 1,396,274
-----------
Expenses:
Management fees (Note 3) .......................... 88,415
Transfer agent fees (Note 3) ...................... 11,340
Custodian fees .................................... 133
Reports to shareholders ........................... 1,590
Registration and filing fees ...................... 29,975
Professional fees ................................. 11,950
Other ............................................. 662
-----------
Total expenses ............................... 144,065
Expenses waived/paid by affiliate (Note 3) ... (144,065)
-----------
Net investment income ....................... 1,396,274
-----------
Realized and unrealized losses:
Net realized loss from investments ............... (20,112)
Net unrealized depreciation on investments ....... (889,175)
-----------
Net realized and unrealized loss ................... (909,287)
-----------
Net increase in net assets resulting from operations $ 486,987
===========
See notes to financial statements.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
Statements of Changes in Net Assets
for the years ended September 30, 1999 and 1998
<TABLE>
<CAPTION>
1999 1998
--------------------------------
<S> <C> <C>
Increase (decrease) in net assets:
Operations:
Net investment income ................................................................... $ 1,396,274 $ 777,125
Net realized gain (loss) from investments ............................................... (20,112) 16,849
Net unrealized appreciation (depreciation) on investments ............................... (889,175) 209,877
--------------------------------
Net increase in net assets resulting from operations ................................ 486,987 1,003,851
Distributions to shareholders from net investment income ................................. (1,391,928) (775,976)
Capital share transactions: (Note 2) ..................................................... 19,230,447 5,388,997
--------------------------------
Net increase in net assets .......................................................... 18,325,506 5,616,872
Net assets (there was no undistributed net investment income at beginning and end of year):
Beginning of year ........................................................................ 14,550,817 8,933,945
--------------------------------
End of year .............................................................................. $ 32,876,323 $ 14,550,817
================================
</TABLE>
See notes to financial statements.
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 a diversified, open-end 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. 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.
c. 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.
d. 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.
2. SHARES OF BENEFICIAL INTEREST
At September 30, 1999, there were an unlimited number of shares authorized
($0.01 par value). Transactions in the Fund's shares were as follows:
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------------------
1999 1998
----------------------------------------------------------------
SHARES AMOUNT SHARES AMOUNT
----------------------------------------------------------------
<S> <C> <C> <C> <C>
Shares sold .................................. 2,311,776 $ 22,889,797 736,173 $ 7,369,970
Shares issued in reinvestment of distributions 73,906 729,087 67,712 678,453
Shares redeemed .............................. (444,661) (4,388,437) (265,706) (2,659,426)
----------------------------------------------------------------
Net increase ................................. 1,941,021 $ 19,230,447 538,179 $ 5,388,997
================================================================
</TABLE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (continued)
3. TRANSACTIONS WITH AFFILIATES
Certain officers and trustees of the Fund are also officers and/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 manager, 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
$15,961.
At September 30, 1999, Franklin Resources owned 20.71% of the Fund.
4. INCOME TAXES
At September 30, 1999, 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, 1999, the Fund has deferred capital losses occurring subsequent
to October 31, 1998 of $20,112. For tax purposes, such losses will be reflected
in the year ending September 30, 2000.
At September 30, 1999, the net unrealized depreciation based on the cost of
investments for income tax purposes of $34,955,631 was as follows:
Unrealized appreciation $134,498
Unrealized depreciation (605,834)
---------
Net unrealized depreciation $(471,336)
=========
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (continued)
4. INCOME TAXES (cont.)
Net realized capital gains and losses differ for financial statement and tax
purposes primarily due to differing treatment of mortgage dollar roll
transactions.
5. INVESTMENT TRANSACTIONS
Purchases and sales of securities (excluding short-term securities) for the year
ended September 30, 1999 aggregated $30,917,202 and $8,499,494, respectively.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Independent Auditors' Report
TO THE BOARD OF TRUSTEES AND SHAREHOLDERS 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, 1999, 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, 1999 by correspondence with the custodian and brokers, provide a
reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
San Francisco, California
November 1, 1999
