SHAREHOLDER LETTER
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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)
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Dear Shareholder:
It's a pleasure to bring you Franklin Strategic Mortgage Portfolio's annual
report for the period ended September 30, 2000.
The U.S. economy continued to strengthen during the 12 months under review as
gross domestic product accelerated at annualized rates of 8.3% in the fourth
quarter of 1999 and 4.8% and 5.6% in the first and second quarters of 2000. This
trend appeared to continue, albeit at a slower pace, through the third quarter
of 2000. Although tight labor markets and increased consumer spending did little
to spur inflation, the Federal Reserve Board (the Fed) raised interest rates
four times to 6.5% during the reporting period. The Fed stated
<TABLE>
<CAPTION>
CONTENTS
<S> <C>
Shareholder Letter ........................................................ 1
Performance Summary ....................................................... 6
Financial Highlights &
Statement of Investments .................................................. 8
Financial Statements ...................................................... 13
Notes to
Financial Statements ...................................................... 16
Independent
Auditors' Report .......................................................... 19
</TABLE>
[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/or interest. Yields and share price are
not guaranteed and will fluctuate with market conditions.
The dollar value, number of shares or principal value, and complete legal titles
of all portfolio holdings are listed in the Fund's Statement of Investments
(SOI). The SOI begins on page 9.
<PAGE>
PORTFOLIO BREAKDOWN
Based on Total Long-Term Investments
<TABLE>
<CAPTION>
9/30/00 9/30/99
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<S> <C> <C>
30-Year Mortgage Pass-Throughs 72.61% 78.45%
Adjustable Rate Mortgage 24.02% 3.79%
15-Year Mortgage Pass-Throughs 3.06% 15.78%
Balloon Mortgage Pass-Throughs 0.31% 0.72%
Cash & Equivalents 0.00% 1.26%
</TABLE>
that demand for goods and services was still outpacing supply despite
technology-driven gains in productivity. However, following growing evidence
that the economy was slowing, the Fed left rates unchanged after the last
increase on May 16.
With the Fed in a tightening mode, short-term Treasury yields rose substantially
during the reporting period. However, expectations for a reduced supply of
longer-term Treasuries led to lower yields. The result of rising short-term
yields and lower long-term yields created an unusual situation called a yield
curve inversion, where shorter-term yields were higher than longer-term yields.
2
<PAGE>
The inverted yield curve had an interesting effect on the valuations of
mortgage-backed pass-through securities, the Fund's principal investments.
Typically, adjustable-rate mortgages (ARMs) are priced based on the yield of
short-term Treasuries. With short-term Treasuries yielding more than long-term,
we were able to purchase ARMs at very attractive yields -- approximately 130
basis points higher than the 30-year Treasury bond -- at considerably lower
interest-rate risk. In doing so, we were able to increase the portfolio's yield
without an equivalent rise in its interest-rate risk profile.
Within this environment, Franklin Strategic Mortgage Portfolio delivered a
one-year cumulative total return of +7.60%, outperforming the 7.44% return of
its benchmark, the Salomon Brothers Mortgage-Backed Securities Index.(2) Over
the long term, the Fund has also delivered solid returns, as shown in the
Performance Summary beginning on page 6.
WHAT IS A MORTGAGE PASS-THROUGH SECURITY?
A mortgage pass-through security represents pooled mortgages that are repackaged
into a security and sold to investors. Such securities pass mortgage holder
principal and interest payments from the originating financial institutions
through a government agency or some other intermediary and then to investors.
(2) Source: Standard and Poor's Micropal. The Salomon Brothers Mortgage-Backed
Securities Index is a total return index that includes approximately 178 GNMA,
FNMA and FHLMC issues. The index is unmanaged and does not include reinvested
dividends. One cannot invest directly in an index, nor is an index
representative of the Fund's portfolio.
3
<PAGE>
DIVIDEND DISTRIBUTIONS*
10/1/99 - 9/30/00
<TABLE>
<CAPTION>
DIVIDEND
MONTH PER SHARE
--------------------------------------------------------------------------------
<S> <C>
October 5.2716 cents
November 5.8753 cents
December 5.5024 cents
January 5.5263 cents
February 5.6254 cents
March 5.6369 cents
April 5.3584 cents
May 5.9202 cents
June 5.6666 cents
July 5.5879 cents
August 5.8761 cents
September 5.7437 cents
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TOTAL 67.5908 CENTS
</TABLE>
Mortgage rates rose slightly during the reporting period, 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 7.70%
on October 1, 1999, to 7.88% on September 30, 2000. Mortgage rates peaked in
late May when the markets expected the Fed to tighten aggressively throughout
the summer. However, later in the summer, it became apparent that the Fed's
previous tightenings were having the desired effect of slowing economic growth
to a more sustainable pace. This kept the Fed from taking any action for the
remainder of the reporting period and paved the way for reduced uncertainty in
the fixed income markets. This environment boosted investor demand for
securities that offer a yield advantage to Treasuries such as mortgage-backed
pass-throughs, which were among the best-performing securities in the fixed
income sector over the past year.
*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.
4
<PAGE>
Looking forward, we are optimistic about the performance of mortgage securities
over the near term and we believe that the portfolio is well-positioned to
provide solid returns for our shareholders.
Sincerely,
/s/Roger A. Bayston
Roger A. Bayston
Portfolio Manager
Franklin Strategic Mortgage Portfolio
This discussion reflects our views, opinions and portfolio holdings as of
September 30, 2000, the end of the reporting period. The information provided is
not a complete analysis of every aspect of any industry, security or the Fund.
Our strategies and the Fund's portfolio composition will change depending on
market and economic conditions. Although historical performance is no guarantee
of future results, these insights may help you understand our investment and
management philosophy.
5
<PAGE>
PERFORMANCE SUMMARY AS OF 9/30/00
One-year total return represents the change in value of an investment for the
period indicated and does not include the sales charge. Distributions will vary
based on earnings of the Fund's portfolio and any profits realized from the sale
of the portfolio's securities, as well as the level of the Fund's operating
expenses. Past distributions are not indicative of future trends. All total
returns include reinvested distributions at net asset value.
CLASS A: Subject to the current, maximum 4.25% initial sales charge. Prior to
7/1/94, 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 and to make certain payments to reduce expenses.
If the manager had not take this action, the Fund's total return and
distribution rate would have been lower and yield for the period would have been
6.46%. 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, maximum sales
charge.
3. Distribution rate is based on an annualization of September's 5.7437 cent per
share monthly dividend and the maximum offering price per share of $10.20 on
9/30/00.
4. Yield, calculated as required by the SEC, is based on the earnings of the
Fund's portfolio for the 30 days ended 9/30/00.
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.
<TABLE>
<CAPTION>
CLASS A
<S> <C> <C>
One-Year Total Return +7.60%
Net Asset Value (NAV) $9.77 (9/30/00) $9.74 (9/30/99)
Change in NAV +$0.03
Distributions (10/1/99-9/30/00) Dividend Income $0.675908
</TABLE>
<TABLE>
<CAPTION>
INCEPTION
CLASS A 1-YEAR 5-YEAR (2/1/93)
--------------------------------------------------------------------------------
<S> <C> <C> <C>
Cumulative Total Return(1) +7.60% +38.92% +64.32%
Average Annual Total Return(2) +3.05% +5.87% +6.10%
</TABLE>
<TABLE>
<CAPTION>
SHARE CLASS A
--------------------------------------------------------------------------------
<S> <C>
Distribution Rate(3) 7.11%
30-Day Standardized Yield(4) 6.91%
</TABLE>
Franklin Strategic Mortgage Portfolio was ranked #6 out of 64 U.S. mortgage
funds in total return for the one-year period and #3 of 48 funds for the
five-year period ended 9/30/00, as measured by Lipper Analytical Services, Inc.,
a nationally recognized mutual fund research organization. Lipper rankings do
not include sales charges, and may have been different if such charges had been
considered. Past performance does not guarantee future results.
For updated performance figures, see "Prices and Performance" at
franklintempleton.com, or call Franklin Templeton Investments at 1-800/342-5236.
Past performance does not guarantee future results.
6
<PAGE>
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, 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.
[CLASS A LINE CHART]
The following line graph compares the performance of Franklin Strategic Mortgage
Portfolio's Class A shares to that of the Salomon Brothers Mortgage-Backed
Securities Index based on a $10,000 investment from 2/1/93 to 9/30/00.
<TABLE>
<CAPTION>
Franklin Salomon
Strategic Brothers
Mortgage Mortgage-Backed
Portfolio Securities Index
--------- ----------------
<S> <C> <C>
02/01/1993 $9,579 $10,000
02/28/1993 $9,721 $10,092
03/31/1993 $9,780 $10,153
04/30/1993 $9,839 $10,222
05/31/1993 $9,859 $10,268
06/30/1993 $10,008 $10,366
07/31/1993 $10,014 $10,410
08/31/1993 $10,130 $10,453
09/30/1993 $10,166 $10,462
10/31/1993 $10,215 $10,497
11/30/1993 $10,133 $10,478
12/31/1993 $10,231 $10,556
01/31/1994 $10,350 $10,663
02/28/1994 $10,188 $10,595
03/31/1994 $9,985 $10,335
04/30/1994 $9,933 $10,270
05/31/1994 $9,959 $10,306
06/30/1994 $9,926 $10,279
07/31/1994 $10,110 $10,479
08/31/1994 $10,139 $10,502
09/30/1994 $10,003 $10,361
10/31/1994 $9,979 $10,358
11/30/1994 $9,953 $10,321
12/31/1994 $10,044 $10,407
01/31/1995 $10,249 $10,641
02/28/1995 $10,512 $10,912
03/31/1995 $10,547 $10,956
04/30/1995 $10,686 $11,102
05/31/1995 $11,034 $11,461
06/30/1995 $11,101 $11,522
07/31/1995 $11,117 $11,545
08/31/1995 $11,229 $11,651
09/30/1995 $11,330 $11,756
10/31/1995 $11,447 $11,656
11/30/1995 $11,572 $12,004
12/31/1995 $11,707 $12,153
01/31/1996 $11,804 $12,246
02/29/1996 $11,710 $12,149
03/31/1996 $11,658 $12,108
04/30/1996 $11,628 $12,052
05/31/1996 $11,592 $12,037
06/30/1996 $11,728 $12,191
07/31/1996 $11,782 $12,240
08/31/1996 $11,779 $12,242
09/30/1996 $11,974 $12,448
10/31/1996 $12,207 $12,689
11/30/1996 $12,377 $12,864
12/31/1996 $12,330 $12,808
01/31/1997 $12,415 $12,917
02/28/1997 $12,438 $12,931
03/31/1997 $12,393 $12,823
04/30/1997 $12,570 $13,018
05/31/1997 $12,680 $13,139
06/30/1997 $12,808 $13,290
07/31/1997 $13,013 $13,536
08/31/1997 $13,004 $13,512
09/30/1997 $13,153 $13,673
10/31/1997 $13,281 $13,820
11/30/1997 $13,313 $13,867
12/31/1997 $13,437 $13,994
01/31/1998 $13,564 $14,124
02/28/1998 $13,595 $14,166
03/31/1998 $13,644 $14,221
04/30/1998 $13,713 $14,301
05/31/1998 $13,810 $14,401
06/30/1998 $13,890 $14,464
07/31/1998 $13,952 $14,535
08/31/1998 $14,097 $14,668
09/30/1998 $14,298 $14,844
10/31/1998 $14,301 $14,827
11/30/1998 $14,389 $14,896
12/31/1998 $14,452 $14,970
01/31/1999 $14,537 $15,073
02/28/1999 $14,465 $15,018
03/31/1999 $14,548 $15,121
04/30/1999 $14,611 $15,195
05/31/1999 $14,515 $15,093
06/30/1999 $14,476 $15,059
07/31/1999 $14,392 $14,956
08/31/1999 $14,382 $14,947
09/30/1999 $14,628 $15,201
10/31/1999 $14,692 $15,282
11/30/1999 $14,705 $15,294
12/31/1999 $14,667 $15,244
01/31/2000 $14,553 $15,126
02/29/2000 $14,716 $15,305
03/31/2000 $14,865 $15,469
04/30/2000 $14,886 $15,476
05/31/2000 $14,901 $15,489
06/30/2000 $15,210 $15,823
07/31/2000 $15,314 $15,925
08/31/2000 $15,551 $16,160
09/30/2000 $15,739 $16,333
</TABLE>
AVERAGE ANNUAL TOTAL RETURN
9/30/00
<TABLE>
<CAPTION>
CLASS A
--------------------------------------------------------------------------------
<S> <C>
1-Year +3.05%
5-Year +5.87%
Since Inception (2/1/93) +6.10%
</TABLE>
*Source: Standard and Poor's Micropal. The Salomon Brothers Mortgage-Backed
Securities Index is a total return index that includes approximately 178 GNMA,
FNMA and FHLMC issues.
Past performance does not guarantee future results.
7
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Highlights
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
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2000 1999 1998 1997 1996
---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net asset value, beginning of year ................. $ 9.74 $ 10.14 $ 9.96 $ 9.74 $ 9.91
---------------------------------------------------------------------
Income from investment operations:
Net investment income ............................. .663 .627 .660 .708 .717
Net realized and unrealized gains (losses) ........ .043 (.400) .179 .220 (.170)
---------------------------------------------------------------------
Total from investment operations ................... .706 .227 .839 .928 .547
---------------------------------------------------------------------
Less distributions from:
Net investment income ............................. (.663) (.627) (.659) (.708) (.717)
In excess of net investment income ................ (.013) -- -- -- --
---------------------------------------------------------------------
Total distributions ................................ (.676) (.627) (.659) (.708) (.717)
---------------------------------------------------------------------
Net asset value, end of year ....................... $ 9.77 $ 9.74 $ 10.14 $ 9.96 $ 9.74
=====================================================================
Total return(a)..................................... 7.60% 2.30% 8.71% 9.84% 5.69%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of year (000's) .................... $ 49,572 $ 32,877 $ 14,551 $ 8,934 $ 6,847
Ratios to average net assets:
Expenses .......................................... -- % -- % -- % -- % -- %
Expenses excluding waiver and payments by affiliate .57% .65% .74% .82% 1.11%
Net investment income ............................. 6.87% 6.32% 6.56% 7.18% 7.26%
Portfolio turnover rate(b).......................... 42.00% 41.72% 38.15% 13.59% 17.64%
</TABLE>
(a) Total return does not reflect sales commissions and is not annualized for
periods less than one year.
(b) The portfolio turnover rate excludes mortgage dollar roll transactions.
See notes to financial statements.
8
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2000
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
---------------------------------------------------------------------------------------------------
<S> <C> <C>
LONG TERM INVESTMENTS 126.3%
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) 13.7%
FHLMC, 6.50%, 11/01/01 ......................................... $ 69,663 $ 69,083
FHLMC, 6.50%, 3/01/09 .......................................... 55,511 54,968
FHLMC, 7.00%, 6/01/09 .......................................... 34,448 34,499
FHLMC, 8.00%, 1/01/10 .......................................... 14,150 14,439
FHLMC, 7.50%, 4/01/10 .......................................... 21,590 21,848
FHLMC, 6.50%, 4/01/11 .......................................... 30,681 30,283
FHLMC, 7.00%, 7/01/11 .......................................... 47,910 47,843
FHLMC, 9.50%, 12/01/22 ......................................... 29,682 31,203
FHLMC, 7.00%, 6/01/24 .......................................... 52,711 51,973
FHLMC, 7.50%, 7/01/24 .......................................... 74,579 74,925
FHLMC, 8.00%, 7/01/24 .......................................... 33,074 33,666
FHLMC, 8.50%, 12/01/24 ......................................... 69,359 71,464
FHLMC, 8.00%, 6/01/25 .......................................... 5,961 6,065
FHLMC, 7.00%, 9/01/25 .......................................... 45,883 45,189
FHLMC, 7.00%, 10/01/25 ......................................... 18,006 17,734
FHLMC, 7.50%, 10/01/25 ......................................... 15,974 16,031
FHLMC, 7.50%, 1/01/26 .......................................... 27,643 27,740
FHLMC, 8.00%, 1/01/26 .......................................... 26,413 26,872
FHLMC, 7.00%, 3/01/26 .......................................... 86,381 84,975
FHLMC, 7.50%, 5/01/26 .......................................... 18,875 18,914
FHLMC, 7.50%, 1/01/27 .......................................... 27,798 27,855
FHLMC, 7.00%, 4/01/28 .......................................... 363,102 356,733
FHLMC, 7.00%, 5/01/28 .......................................... 333,390 327,961
(a) FHLMC, 7.50%, 10/01/28 ........................................ 700,000 699,125
FHLMC, 7.00%, 12/01/29 ......................................... 699,523 686,831
FHLMC, 7.00%, 7/01/30 .......................................... 1,488,692 1,460,532
FHLMC, 7.00%, 8/01/30 .......................................... 1,399,006 1,372,542
(a) FHLMC, 6.00%, 10/01/30 ......................................... 700,000 654,281
(a) FHLMC, 6.50%, 10/01/30 ......................................... 475,941 457,350
-----------
6,822,924
-----------
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) - ADJUSTABLE RATE 20.2%
FHLMC, 7.423%, 11/01/16 ........................................ 1,366,661 1,385,666
FHLMC, 8.50%, 4/01/18 .......................................... 961,619 987,879
FHLMC, 8.348%, 3/01/19 ......................................... 1,202,610 1,221,369
FHLMC, 7.761%, 11/01/19 ........................................ 1,423,099 1,454,785
FHLMC, 7.645%, 5/01/20 ......................................... 1,743,524 1,777,013
FHLMC, 8.364%, 5/01/22 ......................................... 937,500 964,116
FHLMC, 7.803%, 7/01/22 ......................................... 1,544,815 1,577,680
FHLMC, 7.761%, 11/01/25 ........................................ 630,703 645,857
-----------
10,014,365
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FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) 55.4%
FNMA, 6.50%, 9/01/08 ........................................... 55,442 54,944
FNMA, 7.00%, 7/01/09 ........................................... 34,483 34,514
FNMA, 7.50%, 7/01/09 ........................................... 20,421 20,670
FNMA, 6.00%, 3/01/11 ........................................... 795,329 775,107
FNMA, 6.50%, 4/01/11 ........................................... 26,363 26,012
</TABLE>
9
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2000 (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
----------------------------------------------------------------------------------------------------
<S> <C> <C>
LONG TERM INVESTMENTS (CONT.)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) (CONT.)
FNMA, 7.50%, 6/01/11 ............................................... $ 322,021 $ 325,449
FNMA, 7.00%, 11/01/11 .............................................. 16,081 16,052
FNMA, 7.50%, 7/01/12 ............................................... 199,341 201,463
FNMA, 6.00%, 5/01/13 ............................................... 836,087 805,492
FNMA, 5.50%, 5/01/14 ............................................... 698,463 658,929
FNMA, 6.50%, 5/01/14 ............................................... 726,931 713,599
FNMA, 6.00%, 12/01/23 .............................................. 18,260 17,266
FNMA, 6.50%, 6/01/24 ............................................... 304,368 294,399
FNMA, 7.00%, 6/01/24 ............................................... 168,596 166,158
FNMA, 8.50%, 7/01/24 ............................................... 17,066 17,547
FNMA, 8.00%, 1/01/25 ............................................... 43,461 44,180
FNMA, 9.00%, 1/01/25 ............................................... 39,756 41,348
FNMA, 7.50%, 8/01/25 ............................................... 75,813 76,009
FNMA, 7.50%, 11/01/25 .............................................. 15,120 15,160
FNMA, 8.00%, 12/01/25 .............................................. 102,227 103,849
FNMA, 7.00%, 1/01/26 ............................................... 29,405 28,921
FNMA, 7.00%, 6/01/26 ............................................... 42,005 41,293
FNMA, 8.00%, 6/01/26 ............................................... 4,100 4,164
FNMA, 8.00%, 7/01/26 ............................................... 9,765 9,918
FNMA, 8.00%, 8/01/26 ............................................... 19,250 19,552
FNMA, 7.50%, 10/01/26 .............................................. 23,178 23,206
FNMA, 7.00%, 4/01/27 ............................................... 147,865 145,261
FNMA, 6.50%, 12/01/27 .............................................. 1,554,684 1,496,917
FNMA, 6.00%, 3/01/28 ............................................... 883,637 828,101
FNMA, 6.50%, 3/01/28 ............................................... 426,908 410,364
(a) FNMA, 6.00%, 10/01/28 .............................................. 5,560,769 5,194,106
(a) FNMA, 7.00%, 10/01/28 .............................................. 2,695,000 2,640,258
FNMA, 7.00%, 10/01/28 .............................................. 742,086 728,111
FNMA, 6.00%, 12/01/28 .............................................. 894,983 838,735
(a) FNMA, 6.50%, 10/01/29 .............................................. 5,660,134 5,433,729
FNMA, 7.50%, 11/01/29 .............................................. 247,264 247,067
FNMA, 8.50%, 4/01/30 ............................................... 721,599 740,288
FNMA, 7.50%, 6/01/30 ............................................... 998,194 996,895
FNMA, 7.50%, 7/01/30 ............................................... 998,256 996,957
FNMA, 7.50%, 8/01/30 ............................................... 993,860 992,566
(a) FNMA, 8.00%, 10/01/30 .............................................. 1,199,430 1,215,547
-----------
27,440,103
-----------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) - ADJUSTABLE RATE 10.2%
FNMA, 8.033%, 4/01/18 .............................................. 347,770 359,414
FNMA, 7.908%, 12/01/24 ............................................. 796,854 807,847
FNMA, 7.837%, 7/01/25 .............................................. 1,014,050 1,038,780
FNMA, 8.041%, 8/01/27 .............................................. 761,772 776,926
FNMA, 8.744%, 6/01/30 .............................................. 1,998,596 2,098,170
-----------
5,081,137
-----------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, 23.8%
GNMA, 10.00%, 2/15/13 .............................................. 3,706 3,918
GNMA, 7.00%, 4/15/14 ............................................... 708,216 710,317
</TABLE>
10
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2000 (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
--------------------------------------------------------------------------------------
<S> <C> <C>
LONG TERM INVESTMENTS (CONT.)
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, (CONT.)
GNMA, 10.50%, 1/15/16 ...................................... $ 1,475 $ 1,592
GNMA, 9.00%, 12/15/16 ...................................... 65,902 69,341
GNMA, 10.00%, 10/15/17 ..................................... 17,880 18,890
GNMA, 10.00%, 10/15/18 ..................................... 14,424 15,234
GNMA, 10.00%, 12/15/18 ..................................... 59,275 62,604
GNMA, 10.00%, 2/15/19 ...................................... 1,258 1,329
GNMA, 9.50%, 10/15/20 ...................................... 49,216 51,777
GNMA, 8.25%, 1/15/21 ....................................... 221,815 227,438
GNMA, 8.25%, 2/15/21 ....................................... 173,965 178,375
GNMA, 8.25%, 3/15/21 ....................................... 151,524 155,366
GNMA, 8.25%, 5/15/21 ....................................... 335,764 344,276
GNMA, 8.25%, 6/15/21 ....................................... 97,036 99,497
GNMA, 8.25%, 10/15/21 ...................................... 130,133 133,432
GNMA, 8.00%, 2/15/23 ....................................... 86,409 88,341
GNMA, 7.00%, 6/15/23 ....................................... 138,301 136,786
GNMA, 7.50%, 6/15/23 ....................................... 31,163 31,384
GNMA, 6.50%, 1/15/24 ....................................... 180,189 174,681
GNMA, 8.50%, 7/15/24 ....................................... 34,306 35,419
GNMA, 8.00%, 1/15/25 ....................................... 12,523 12,795
GNMA, 7.50%, 9/15/25 ....................................... 11,277 11,335
GNMA, 7.50%, 9/15/25 ....................................... 30,197 30,351
GNMA, 7.00%, 1/15/26 ....................................... 32,986 32,560
GNMA, 7.50%, 1/15/26 ....................................... 36,536 36,717
GNMA, 7.00%, 3/15/26 ....................................... 14,749 14,559
GNMA, 7.50%, 5/15/26 ....................................... 10,790 10,844
GNMA, 8.00%, 6/15/26 ....................................... 30,152 30,778
GNMA, 8.50%, 8/15/26 ....................................... 4,225 4,359
GNMA, 7.50%, 10/15/26 ...................................... 25,043 25,168
GNMA, 8.00%, 7/15/27 ....................................... 668,903 682,252
GNMA, 7.50%, 9/15/27 ....................................... 569,252 571,872
GNMA, 8.00%, 11/15/27 ...................................... 23,596 24,068
GNMA, 7.00%, 12/15/27 ...................................... 990,812 977,395
GNMA, 8.00%, 1/15/28 ....................................... 661,123 674,138
GNMA, 6.50%, 4/15/28 ....................................... 424,317 409,154
GNMA, 7.50%, 5/15/28 ....................................... 529,996 532,293
(a) GNMA, 7.00%, 10/01/28 ...................................... 700,000 689,719
GNMA, 6.50%, 2/15/29 ....................................... 138,029 133,094
GNMA, 6.00%, 3/15/29 ....................................... 484,538 455,300
GNMA, 7.50%, 10/15/29 ...................................... 696,614 699,382
GNMA, 8.00%, 1/15/30 ....................................... 700,069 713,319
GNMA II, 9.00%, 8/20/06 .................................... 5,497 5,661
GNMA II, 9.00%, 12/20/06 ................................... 40,178 41,373
GNMA II, 9.00%, 11/20/15 ................................... 15,422 16,110
GNMA II, 9.00%, 11/20/19 ................................... 9,644 10,064
GNMA II, 9.00%, 4/20/20 .................................... 32,047 33,421
GNMA II, 10.50%, 6/20/20 ................................... 870 930
GNMA II, 9.00%, 12/20/21 ................................... 30,810 32,102
GNMA II, 9.00%, 9/20/24 .................................... 16,374 16,990
</TABLE>
11
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2000 (CONT.)
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
LONG TERM INVESTMENTS (CONT.)
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, (CONT.)
GNMA II, 9.00%, 10/20/24 .................................................................. $ 32,993 $ 34,232
GNMA II, 9.00%, 11/20/24 .................................................................. 32,082 33,287
GNMA II, 9.00%, 12/20/24 .................................................................. 11,679 12,118
GNMA II, 9.00%, 3/20/25 ................................................................... 19,479 20,184
GNMA II, 6.50%, 1/20/26 ................................................................... 2,280,702 2,196,817
GNMA II, 8.00%, 8/20/26 ................................................................... 9,778 9,927
------------
11,774,665
------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) - ADJUSTABLE RATE, SF, 1.9%
GNMA II, 7.125%, 11/20/25 ................................................................. 406,676 409,593
GNMA II, 6.75%, 7/20/27 ................................................................... 523,487 526,683
------------
936,276
------------
PRUDENTIAL HOME MORTGAGE SECURITIES (PHMS) - ADJUSTABLE RATE 1.1%
PHMS, 8.682%, 7/25/18 ..................................................................... 560,241 559,541
------------
TOTAL LONG TERM INVESTMENTS (COST $62,569,802) ............................................ 62,629,011
------------
SHORT TERM INVESTMENTS .3%
FHLMC, 9.00%, 6/01/01 ..................................................................... 7,022 7,011
FNMA, 6.00%, 3/01/01 ...................................................................... 126,034 124,212
GNMA, 11.00%, 1/15/01 ..................................................................... 1,217 1,241
GNMA II, 9.00%, 8/20/01 ................................................................... 1,078 1,078
------------
TOTAL SHORT TERM INVESTMENTS (COST $135,640) .............................................. 133,542
------------
TOTAL INVESTMENTS BEFORE REPURCHASE AGREEMENTS (COST $62,705,442) ......................... 62,762,553
------------
(b) REPURCHASE AGREEMENT 6.4%
Joint Repurchase Agreement, 6.515%, 10/2/00, (Maturity Value $3,185,897) (COST $3,184,168) 3,184,168 3,184,168
Barclays Capital Inc.
Bear, Sterns & Co. Inc.
Chase Securities Inc.
Deutche Bank Securities
Donaldson, Lufkin & Jenrette Securities Corp.
Dresdner Kleinwort Benson, North America LLC
Goldman, Sachs & Co.
Lehman Brothers Inc.
Nesbitt Burns Securities Inc.
Paribas Corp.
Societe Generale
UBS Warburg
------------
TOTAL INVESTMENTS (COST $65,889,610) 133.0% ............................................... 65,946,721
OTHER ASSETS, LESS LIABILITIES (33.0%) .................................................... (16,374,583)
------------
NET ASSETS 100.0% ......................................................................... $ 49,572,138
============
</TABLE>
PORTFOLIO ABBREVIATIONS:
SF - Single Family
(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, 2000, all repurchase
agreements had been entered into on that date.
See notes to financial statements.
12
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements
STATEMENT OF ASSETS AND LIABILITIES
SEPTEMBER 30, 2000
<TABLE>
<S> <C>
Assets:
Investments in securities:
Cost ................................................................................... $65,889,610
===========
Value .................................................................................. 65,946,721
Receivables:
Investment securities sold ............................................................. 111,048
Capital shares sold .................................................................... 384,585
Interest ............................................................................... 381,073
Affiliates ............................................................................. 253
-----------
Total assets ....................................................................... 66,823,680
-----------
Liabilities:
Payables:
Investment securities purchased ........................................................ 16,911,150
Capital shares redeemed ................................................................ 255,611
Shareholders ........................................................................... 828
Distributions to shareholders ........................................................... 83,953
-----------
Total liabilities .................................................................. 17,251,542
-----------
Net assets, at value .............................................................. $49,572,138
===========
Net assets consist of:
Accumulated distributions in excess of net investment income ............................ $ (16,410)
Net unrealized appreciation ............................................................. 57,111
Accumulated net realized loss ........................................................... (303,160)
Capital shares .......................................................................... 49,834,597
-----------
Net assets, at value .............................................................. $49,572,138
===========
Net asset value per share ($49,572,138 / 5,075,775 shares outstanding) ................... $ 9.77
===========
Maximum offering price per share ($9.77 / 95.75%) ........................................ $ 10.20
===========
</TABLE>
See notes to financial statements.
13
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
STATEMENT OF OPERATIONS
FOR THE YEAR ENDED SEPTEMBER 30, 2000
<TABLE>
<S> <C>
Investment income:
Interest ................................................................................. $2,740,732
----------
Expenses:
Management fees (Note 3) ................................................................. 159,349
Transfer agent fees (Note 3) ............................................................. 29,454
Custodian fees ........................................................................... 452
Reports to shareholders .................................................................. 2,476
Registration and filing fees ............................................................. 12,301
Professional fees (Note 3) ............................................................... 22,647
Other .................................................................................... 708
----------
Total expenses ...................................................................... 227,387
Expenses waived/paid by affiliate (Note 3) .......................................... (227,387)
----------
Net investment income .............................................................. 2,740,732
----------
Realized and unrealized gains (losses):
Net realized loss from investments ....................................................... (82,910)
Net unrealized appreciation on investments ............................................... 521,897
----------
Net realized and unrealized gain .......................................................... 438,987
----------
Net increase in net assets resulting from operations ...................................... $3,179,719
==========
</TABLE>
See notes to financial statements.
14
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Financial Statements (continued)
STATEMENTS OF CHANGES IN NET ASSETS
FOR THE YEARS ENDED SEPTEMBER 30, 2000 AND 1999
<TABLE>
<CAPTION>
2000 1999
---- ----
<S> <C> <C>
Increase (decrease) in net assets:
Operations:
Net investment income ............................................................ $ 2,740,732 $ 1,396,274
Net realized loss from investments ............................................... (82,910) (20,112)
Net unrealized appreciation (depreciation) on investments ........................ 521,897 (889,175)
------------------------------
Net increase in net assets resulting from operations ......................... 3,179,719 486,987
Distributions to shareholders from:
Net investment income ............................................................ (2,740,732) (1,391,928)
In excess of net investment income ............................................... (65,311) --
------------------------------
Total distributions to shareholders ............................................... (2,806,043) (1,391,928)
Capital share transactions: (Note 2) .............................................. 16,322,139 19,230,447
------------------------------
Net increase in net assets ................................................... 16,695,815 18,325,506
Net assets
Beginning of year ................................................................. 32,876,323 14,550,817
------------------------------
End of year ....................................................................... $ 49,572,138 $ 32,876,323
==============================
Accumulated distributions in excess of net investment income included in net assets:
End of year ....................................................................... $ (16,410) $ --
==============================
</TABLE>
See notes to financial statements.
15
<PAGE>
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.
e. MORTGAGE DOLLAR ROLLS:
The Fund enters into dollar roll transactions in which it agrees to sell and
repurchase mortgage backed securities. Realized gains and losses are deferred if
the securities are substantially similar.
16
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (continued)
2. SHARES OF BENEFICIAL INTEREST
At September 30, 2000, 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,
-----------------------------------------------------------------
2000 1999
-----------------------------------------------------------------
SHARES AMOUNT SHARES AMOUNT
-----------------------------------------------------------------
<S> <C> <C> <C> <C>
Shares sold .................................. 2,880,866 $ 27,655,235 2,311,776 $ 22,889,797
Shares issued in reinvestment of distributions 177,765 1,708,513 73,906 729,087
Shares redeemed .............................. (1,359,052) (13,041,609) (444,661) (4,388,437)
-----------------------------------------------------------------
Net increase ................................. 1,699,579 $ 16,322,139 1,941,021 $ 19,230,447
=================================================================
</TABLE>
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 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>
.40% First $250 million
.38% Over $250 million, up to and including $500 million
.36% 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 year of
$1,593.
At September 30, 2000, Franklin Resources owned 13.84% of the Fund.
Included in professional fees are legal fees of $10,856 that were paid to a law
firm in which a partner is an officer of the fund.
17
<PAGE>
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
Notes to Financial Statements (continued)
4. INCOME TAXES
At September 30, 2000, the Fund had tax basis capital losses of $164,799 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
2008 20,112
--------
$164,799
========
</TABLE>
At September 30, 2000, the Fund has deferred capital losses occurring subsequent
to October 31, 1999 of $108,887. For tax purposes, such losses will be reflected
in the year ending September 31, 2001.
At September 30, 2000, the net unrealized appreciation based on the cost of
investments for income tax purposes of $65,913,462 was as follows:
<TABLE>
<S> <C>
Unrealized appreciation $507,980
Unrealized depreciation (474,721)
--------
Net unrealized appreciation $ 33,259
========
</TABLE>
Distributions of income to shareholders may not equal net investment income due
to differing treatments of mortgage roll transactions for book and tax purposes.
5. INVESTMENT TRANSACTIONS
Purchases and sales of securities (excluding short-term securities) for the
period ended September 30, 2000 aggregated $45,667,867 and $18,802,868,
respectively.
18
<PAGE>
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, 2000, 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 accounting principles generally accepted in the
United States of America. 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 auditing standards generally accepted in
the United States of America 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, 2000 by
correspondence with the custodian and brokers, provide a reasonable basis for
the opinion expressed above.
PricewaterhouseCoopers LLP
San Francisco, California
November 6, 2000
19
<PAGE>
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