UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSR
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT
INVESTMENT COMPANIES
Investment Company Act file number 811-07288
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FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
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(Exact name of registrant as specified in charter)
ONE FRANKLIN PARKWAY, SAN MATEO, CA 94403-1906
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(Address of principal executive offices) (Zip code)
CRAIG S. TYLE, ONE FRANKLIN PARKWAY, SAN MATEO, CA 94403-1906
-------------------------------------------------------------
(Name and address of agent for service)
Registrant's telephone number, including area code: 650 312-2000
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Date of fiscal year end: 9/30
----
Date of reporting period: 9/30/08
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ITEM 1. REPORTS TO STOCKHOLDERS.
(GRAPHIC)
SEPTEMBER 30, 2008
ANNUAL REPORT AND SHAREHOLDER LETTER
FIXED INCOME
FRANKLIN
STRATEGIC MORTGAGE PORTFOLIO
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(FRANKLIN TEMPLETON INVESTMENTS(R) LOGO)
FRANKLIN - Templeton - Mutual Series
Franklin Templeton Investments
GAIN FROM OUR PERSPECTIVE(R)
Franklin Templeton's distinct multi-manager structure combines the specialized
expertise of three world-class investment management groups--Franklin, Templeton
and Mutual Series.
SPECIALIZED EXPERTISE Each of our portfolio management groups operates
autonomously, relying on its own research and
staying true to the unique investment disciplines
that underlie its success.
FRANKLIN. Founded in 1947, Franklin is a recognized
leader in fixed income investing and also brings
expertise in growth- and value-style U.S. equity
investing.
TEMPLETON. Founded in 1940, Templeton pioneered
international investing and, in 1954, launched what
has become the industry's oldest global fund. Today,
with offices in over 25 countries, Templeton offers
investors a truly global perspective.
MUTUAL SERIES. Founded in 1949, Mutual Series is
dedicated to a unique style of value investing,
searching aggressively for opportunity among what it
believes are undervalued stocks, as well as
arbitrage situations and distressed securities.
TRUE DIVERSIFICATION Because our management groups work independently and
adhere to different investment approaches, Franklin,
Templeton and Mutual Series funds typically have
distinct portfolios. That's why our funds can be
used to build truly diversified allocation plans
covering every major asset class.
RELIABILITY YOU CAN TRUST At Franklin Templeton Investments, we seek to
consistently provide investors with exceptional
risk-adjusted returns over the long term, as well as
the reliable, accurate and personal service that has
helped us become one of the most trusted names in
financial services.
MUTUAL FUNDS | RETIREMENT PLANS | 529 COLLEGE SAVINGS PLANS | SEPARATE ACCOUNTS
(GRAPHIC)
Not part of the annual report
Contents
CEO'S MESSAGE ............................................................. 1
ANNUAL REPORT
Franklin Strategic Mortgage Portfolio ..................................... 4
Performance Summary ....................................................... 9
Your Fund's Expenses ...................................................... 11
Financial Highlights and Statement of Investments ......................... 13
Financial Statements ...................................................... 20
Notes to Financial Statements ............................................. 23
Report of Independent Registered Public Accounting Firm ................... 31
Tax Designation ........................................................... 32
Board Members and Officers ................................................ 33
Shareholder Information ................................................... 38
A Message from Gregory E. Johnson,
President and Chief Executive Officer of Franklin Resources, Inc.
October 31, 2008
Dear Shareholder:
The enclosed annual report for Franklin Strategic Mortgage Portfolio covers the
12 months ended September 30, 2008, but I would like to add some comments on
market events that occurred in October. Recent market volatility has been
jarring to everyone, including those of us who have worked in financial markets
for many years. Bank lending around the world has seized up, and the fallout has
impacted venerable firms alongside broader stock and bond indexes.
This environment is bound to provoke great concern, but it's equally important
to put the latest market developments in perspective. That's why I'd like to
offer a few thoughts on these events, our company's approach to investing and
the strong health of our organization.
A key point to recognize is that global financial turmoil is being addressed by
global action. Central banks around the world have coordinated their efforts to
cut interest rates and supply liquidity to frozen funding markets. A number of
governments have also intervened to rescue major financial institutions or find
an orderly way for them to be acquired. Here in the U.S., the Federal Reserve
and Treasury Department have moved rapidly to establish new programs for easing
money market pressures and handling troubled financial assets.
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NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE
Not part of the annual report | 1
The outcome of all these efforts may take a while to be realized, but I believe
the latest actions here and abroad mark a significant turning point for global
capital markets.
It's also important to remember that as daunting as current market conditions
may be, we have navigated through other periods of market volatility. U.S. stock
markets recorded three bear markets during the 1960s as the nation grappled with
the Vietnam War and a turbulent economy.(1) The quintupling of oil prices in
1973 led to a deep U.S. recession and a stock market plunge of 45.1% from
January 1973 through December 1974.(1) And the "Black Monday" stock market crash
of 1987 remains the largest single-day percentage decline in the history of the
Dow Jones Industrial Average.(2)
Advice applicable throughout these upheavals remains true today. The late Sir
John Templeton, writing 15 years ago, ended a list of his core investment
principles with these thoughts: "Do not be fearful or negative too often.... For
100 years optimists have carried the day in U.S. stocks. Even in the dark '70s,
many professional money managers -- and many individual investors too -- made
money in stocks .... In this century or the next it's still 'Buy low, sell
high.'"(3)
Sir John knew these simple concepts were difficult to execute in the face of
pessimism. Nonetheless, that is precisely how our Franklin, Templeton and Mutual
Series portfolio managers are contending with today's challenging environment.
They are using their expertise to sort through investment opportunities,
avoiding those firms that have become merely cheap and identifying those firms
best positioned to be eventual winners. This kind of rigorous, bottom-up,
security-by-security analysis is the fundamental investment discipline practiced
across our global platform.
These asset management strengths are also the core of our business. Unlike
financial firms that have dominated recent headlines, Franklin Templeton derives
its revenue primarily from investment management, not investment banking or
securities brokerage. Additionally, our assets under management are diversified
by investment objective, clientele and geographic region. Diversified
positioning helps our firm maintain healthy operating margins even when volatile
markets reduce assets under management. It is also important to note that
maintaining a strong balance sheet has been a pillar of our management strategy.
We have a substantial pool of cash and investments and low levels of
(1.) Source: Ned Davis Research, Inc.
(2.) Source: NYSE Euronext. The Dow Jones Industrial Average is price weighted
based on the average market price of 30 blue chip stocks of companies that
are generally industry leaders.
(3.) Source: "16 Rules for Investment Success" by Sir John Templeton.
2 | Not part of the annual report
debt, and we are in the enviable position of not having to depend on credit to
meet our operating needs. In fact, our strong franchise, sound capitalization
and minimal leverage led Standard & Poor's to recently raise its credit ratings
on Franklin Resources, Inc. (BEN) to the highest level currently applied to a
publicly traded asset manager.(4)
Franklin Templeton's six-decade growth into a premier global asset manager has
given us the conviction that although conditions remain challenging, there are
ample reasons to be optimistic about eventual market stabilization and recovery.
Being able to take advantage of markets shaken by maximum pessimism has helped
our firm develop into an organization that stretches across 29 countries and
manages assets for more than 20 million shareholder accounts.
In the enclosed annual report for Franklin Strategic Mortgage Portfolio, the
portfolio managers discuss market conditions, investment decisions and Fund
performance during the 12 months ended September 30, 2008. The report contains
additional performance data and financial information. Our website,
FRANKLINTEMPLETON.COM, offers more timely discussions, daily prices, portfolio
holdings and other information. We encourage you to discuss your concerns with
your financial advisor, who can review your overall portfolio, reassess your
goals and help you stay focused on the long term. As times like these
illustrate, all securities markets fluctuate, as do fund share prices.
We are grateful for the trust you have placed in Franklin Templeton and remain
focused on serving your investment needs.
Sincerely,
/s/ Gregory E. Johnson
Gregory E. Johnson
President and Chief Executive Officer
Franklin Resources, Inc.
THIS LETTER REFLECTS OUR ANALYSIS AND OPINIONS AS OF OCTOBER 31, 2008. THE
INFORMATION IS NOT A COMPLETE ANALYSIS OF EVERY ASPECT OF ANY MARKET, COUNTRY,
INDUSTRY, SECURITY OR FUND. STATEMENTS OF FACT ARE FROM SOURCES CONSIDERED
RELIABLE.
(4.) Source: Standard & Poor's press release, 10/6/08.
Not part of the annual report | 3
Annual Report
Franklin Strategic Mortgage Portfolio
YOUR FUND'S GOAL AND MAIN INVESTMENTS: Franklin Strategic Mortgage Portfolio
seeks high total return (a combination of high current income and capital
appreciation) relative to the performance of the general mortgage securities
market by investing at least 80% of its net assets in mortgage securities. The
Fund normally focuses its investments in mortgage pass-through securities, which
are securities representing interests in "pools" of mortgage loans issued or
guaranteed by the U.S. government, its agencies or instrumentalities. Some of
the Fund's investments may include securities issued by government-sponsored
entities, such as Fannie Mae and Freddie Mac.(1)
PORTFOLIO BREAKDOWN
Based on Total Investments as of 9/30/08
(PIE CHART)
Federal National Mortgage Association
(FNMA) 40.7%
Federal Home Loan Mortgage Corp.
(FHLMC) 26.5%
Asset-Backed Securities & Commercial
Mortgage-Backed Securities 23.7%
Government National Mortgage
Association (GNMA) 4.9%
Short-Term Investments 4.2%
PERFORMANCE DATA REPRESENT PAST PERFORMANCE, WHICH DOES NOT GUARANTEE FUTURE
RESULTS. INVESTMENT RETURN AND PRINCIPAL VALUE WILL FLUCTUATE, AND YOU MAY HAVE
A GAIN OR LOSS WHEN YOU SELL YOUR SHARES. CURRENT PERFORMANCE MAY DIFFER FROM
FIGURES SHOWN. PLEASE VISIT FRANKLINTEMPLETON.COM OR CALL (800) 342-5236 FOR
MOST RECENT MONTH-END PERFORMANCE.
This annual report for Franklin Strategic Mortgage Portfolio covers the fiscal
year ended September 30, 2008.
PERFORMANCE OVERVIEW
For the year under review, Franklin Strategic Mortgage Portfolio - Class A had a
- -1.04% cumulative total return. The Fund underperformed its benchmark,
(1.) Securities owned by the Fund but not shares of the Fund are guaranteed by
the U.S. government, its agencies or instrumentalities as to the timely
payment of principal and interest. Although U.S. government-sponsored
entities may be chartered or sponsored by acts of Congress, their
securities are neither insured nor guaranteed by the U.S. Treasury. Please
refer to the Fund's prospectus for a detailed discussion regarding various
levels of credit support for government agency or instrumentality
securities. The Fund's yield and share price are not guaranteed and will
fluctuate with market conditions.
THE DOLLAR VALUE, NUMBER OF SHARES OR PRINCIPAL AMOUNT, AND NAMES OF ALL
PORTFOLIO HOLDINGS ARE LISTED IN THE FUND'S STATEMENT OF INVESTMENTS (SOI). THE
SOI BEGINS ON PAGE 14.
4 | Annual Report
the Citigroup U.S. Broad Investment-Grade (USBIG) Mortgage Index, which had a
+7.30% total return for the same period.(2) For comparison, the Lipper U.S.
Mortgage Funds Classification Average returned +0.42%, and the Barclays Capital
(BC; formerly Lehman Brothers) U.S. Treasury Index, a component of the BC U.S.
Government Index, returned +8.73%.(3) You can find the Fund's long-term
performance data in the Performance Summary beginning on page 9.
ECONOMIC AND MARKET OVERVIEW
During the 12 months under review, financial market conditions deteriorated
sharply, weighing heavily on the U.S. economy as the credit crisis that
originated in the U.S. housing market worsened. Job losses mounted and the
unemployment rate rose to 6.1% during the reporting period.(4) Home prices
continued to fall and default rates rose as wages remained essentially flat.
Waning consumer confidence led to a pullback in consumer spending as the impact
of the government's tax rebates dissipated. These factors as well as upward
inflationary pressures from a weak U.S. dollar and high food, energy and
commodity prices burdened the overall economy. Economic activity was generally
sluggish during the reporting period as the economy contracted in the fourth
quarter of 2007, registering a -0.2% annualized growth rate before staging a
modest recovery in the first half of 2008. Gross domestic product (GDP) grew at
a 0.9% annualized rate in the first quarter of 2008 and 2.8% in the second
quarter largely due to rising exports and increased government spending.
However, as the financial turmoil intensified in the third quarter of 2008, GDP
fell an estimated annualized 0.3%.
(2.) Source: (C) 2008 Morningstar. All Rights Reserved. The information
contained herein: (1) is proprietary to Morningstar and/or its content
providers; (2) may not be copied or distributed; and (3) is not warranted
to be accurate, complete or timely. Neither Morningstar nor its content
providers are responsible for any damages or losses arising from any use of
this information. The Citigroup USBIG Mortgage Index is the mortgage
component of the Citigroup USBIG Bond Index and comprises 30- and 15-year
GNMA, FNMA and FHLMC securities and FNMA and FHLMC balloon mortgages. In
previous reports, we referred to this index as the Citigroup Mortgage
Index.
(3.) Sources: Lipper Inc.; (C) 2008 Morningstar. The Lipper U.S. Mortgage Funds
Classification Average is calculated by averaging the total return for all
funds within the Lipper U.S. Mortgage Funds classification in the Lipper
Open-End underlying funds universe for the period indicated. Lipper U.S.
Mortgage Funds are defined as funds that invest primarily in
mortgages/securities issued or guaranteed as to principal and interest by
the U.S. government and certain federal agencies. For the 12-month period
ended 9/30/08, the Lipper U.S. Mortgage Funds Classification Average
consisted of 89 funds. Lipper calculations do not include sales charges or
subsidization by a fund's manager. The Fund's performance relative to the
average might have differed if these or other factors had been considered.
The BC U.S. Treasury Index includes public obligations of the U.S. Treasury
with a remaining maturity of one year or more. Treasuries, if held to
maturity, offer a fixed rate of return and fixed principal value; their
interest payments and principal are guaranteed. The Fund's investment
return and share price fluctuate with market conditions.
The indexes are unmanaged and include reinvestment of any income or
distributions. One cannot invest directly in an index, nor is an index
representative of the Fund's portfolio.
(4.) Source: Bureau of Labor Statistics.
Annual Report | 5
Oil prices soared to a record high in July, rising above $145 per barrel, before
dramatically retreating to $101 by period-end. Many other commodities such as
agricultural products and precious and base metals followed similar trends.
September's inflation rate was an annual 4.9%, largely due to higher food and
energy costs. Core inflation, which excludes such costs, rose at a more moderate
2.5% annual rate; however, this level was above the Federal Reserve Board's
(Fed's) informal target range of 1.5%-2.0%.(4) The core personal consumption
expenditures price index reported a 12-month increase of 2.4%.(5)
Amid a series of events that included massive government intervention and
emergency funding, the Fed was focused primarily on restoring liquidity and
confidence to unsettled financial markets. The Fed cut interest rates six times
over the 12-month period, bringing the federal funds target rate to 2.00%, and
it implemented a series of unconventional measures aimed at easing strained
credit conditions. The U.S. Treasury Department also agreed to temporarily
guarantee money market fund losses after the Reserve Primary Fund and two others
"broke the buck," falling below one dollar in value. In the final days of the
reporting period, U.S. Treasury Secretary Henry Paulson and Fed Chairman Ben
Bernanke proposed a $700 billion bailout plan intended to save the financial
system.
Volatility remained high throughout the reporting period but intensified in
September as stocks fluctuated wildly and Treasury prices soared. Panicked
investors drove the yield on the three-month Treasury bill to a multi-decade low
and LIBOR rates, which banks charge each other for loans, jumped to record
highs. Fixed income spreads generally widened relative to Treasury yields over
the period due to heightened market turbulence. Investors continued to seek the
relative safety of short- and intermediate-term U.S. Treasury securities as
Treasury yields declined and the yield curve steepened. Short-term, two- and
five-year yields fell significantly, with the two-year bill yielding 2.00% at
the end of September, down from 3.97% a year earlier. Over the same period, the
10-year U.S. Treasury note yield declined from 4.59% to 3.85%.
INVESTMENT STRATEGY
We invest at least 80% of the Fund's net assets in mortgage securities. Normally
we focus on mortgage pass-through securities issued or guaranteed by the
Government National Mortgage Association (Ginnie Mae), Fannie Mae and Freddie
Mac. At least 65% of total assets are invested in securities rated AAA by
Standard & Poor's Rating Group (S&P) or Fitch, or Aaa by Moody's
(5.) Source: Bureau of Economic Analysis.
6 | Annual Report
Investors Service (Moody's), independent credit rating agencies. For the
remaining 35% of portfolio securities, at least 20% will be rated at least BBB
by S&P or Fitch, or Baa by Moody's, and up to 15% may be invested in securities
rated below BBB by S&P or Fitch, or Baa by Moody's. If unrated, securities will
be deemed of comparable quality by the Fund's manager. Within these parameters,
we rely on our research to help us identify attractive investment opportunities.
MANAGER'S DISCUSSION
The 12-month review period was marked by volatility and heightened concerns over
financial market and economic instability. Despite the government's seizure and
perceived near-explicit backing of Fannie Mae (FNMA) and Freddie Mac (FHLMC),
and the resolutions of numerous troubled financial institutions, investors
feared others would fail. As investor confidence waned, lenders became reluctant
to extend credit. Financial market stresses and money market dislocations
intensified, prompting financial institutions to borrow record amounts from the
Fed as the economy's fundamentals weakened. Credit market turmoil led to
significant losses and write-downs by financial institutions, reducing credit
availability and causing a general repricing of risk globally. The credit
contraction, along with high energy and commodity prices, housing market
weakness, and a pullback in consumer spending contributed to heightened concerns
of slowing economic growth rates.
In this volatile environment, our performance was somewhat buffered by the
positive returns of high credit-quality agency-issued mortgage-backed securities
(MBS). For example, Ginnie Mae (GNMA), FNMA and FHLMC agency securities
performed well, and the BC Fixed Rate MBS Index had a +7.02% total return for
the 12 months ended September 30, 2008.(6) Commercial MBS (CMBS), asset-backed
securities (ABS) and corporate investment-grade securities underperformed the
broader market substantially and had returns of -6.03%, -7.04% and -6.78%,
respectively.(7) For most of the period, we generally increased our allocation
to higher-coupon conventional agency MBS as we believed the prepayment risk for
these types of securities would continue to ease.
(6.) (C) 2008 Morningstar. The BC Fixed Rate MBS Index is the MBS fixed rate
component of the BC U.S. Aggregate Index and covers the mortgage-backed
pass-through securities of Ginnie Mae, Fannie Mae, and Freddie Mac. The MBS
Index is formed by grouping the universe of over 600,000 individual fixed
rate MBS pools into approximately 3,500 generic aggregates.
(7.) (C) 2008 Morningstar. The BC CMBS Employee Retirement Income Security Act
(ERISA)-Eligible Index is the commercial MBS component of the BC U.S.
Aggregate Index and includes investment-grade securities that are
ERISA-eligible under the underwriter's exemption. The BC ABS Index is the
ABS component of the BC U.S. Aggregate Index and includes credit and
charge, auto, home equity, utility and manufactured housing loans. The BC
U.S. Corporate Investment Grade Index is the corporate component of the BC
U.S. Aggregate Index and includes investment-grade industrial, utility and
finance corporate debentures and secured notes.
DIVIDEND DISTRIBUTIONS*
10/1/07-9/30/08
MONTH DIVIDEND PER SHARE
- -------- ------------------
October 4.6962 cents
November 4.3197 cents
December 4.1858 cents
January 4.2779 cents
February 4.2410 cents
March 4.2825 cents
April 4.3510 cents
May 4.3569 cents
June 4.6652 cents
July 4.5248 cents
August 4.3205 cents
September 4.8495 cents
-------------
TOTAL 53.0710 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. All Fund
distributions will vary depending upon current market conditions, and past
distributions are not indicative of future trends.
Annual Report | 7
Prepayment risk fell during the fiscal year largely due to the generally slower
U.S. housing market, higher mortgage rates and tighter underwriting standards
instituted by mortgage originators.
Conversely, other mortgage-related ABS and CMBS experienced significant
volatility and detracted from the Fund's performance during the reporting
period. However, most of our exposure to those areas of the market was in the
highest-rated securities -- those at the top of the capital structure -- which
was consistent with our investment strategy. The mortgage-related ABS that we
held were typically short-term, AAA-rated, floating rate securities protected
from the types of default problems that were the market's chief concern. Based
on our analysis, we maintained our exposure to CMBS as we found the sector's
credit fundamentals generally positive. The Fund's CMBS allocations were mostly
AAA- and AA-rated securities that are high in the capital structure and benefit
from high levels of credit protection.
Thank you for your continued participation in Franklin Strategic Mortgage
Portfolio. We look forward to serving your future investment needs.
(PHOTO OF ROGER A. BAYSTON)
/s/ Roger A. Bayston
Roger A. Bayston, CFA
(PHOTO OF PAUL VARUNOK)
/s/ Paul Varunok
Paul Varunok
Portfolio Management Team
Franklin Strategic Mortgage Portfolio
THE FOREGOING INFORMATION REFLECTS OUR ANALYSIS, OPINIONS AND PORTFOLIO HOLDINGS
AS OF SEPTEMBER 30, 2008, THE END OF THE REPORTING PERIOD. THE WAY WE IMPLEMENT
OUR MAIN INVESTMENT STRATEGIES AND THE RESULTING PORTFOLIO HOLDINGS MAY CHANGE
DEPENDING ON FACTORS SUCH AS MARKET AND ECONOMIC CONDITIONS. THESE OPINIONS MAY
NOT BE RELIED UPON AS INVESTMENT ADVICE OR AN OFFER FOR A PARTICULAR SECURITY.
THE INFORMATION IS NOT A COMPLETE ANALYSIS OF EVERY ASPECT OF ANY MARKET,
COUNTRY, INDUSTRY, SECURITY OR THE FUND. STATEMENTS OF FACT ARE FROM SOURCES
CONSIDERED RELIABLE, BUT THE INVESTMENT MANAGER MAKES NO REPRESENTATION OR
WARRANTY AS TO THEIR COMPLETENESS OR ACCURACY. ALTHOUGH HISTORICAL PERFORMANCE
IS NO GUARANTEE OF FUTURE RESULTS, THESE INSIGHTS MAY HELP YOU UNDERSTAND OUR
INVESTMENT MANAGEMENT PHILOSOPHY.
8 | Annual Report
Performance Summary as of 9/30/08
Your dividend income will vary depending on dividends or interest paid by
securities in the Fund's portfolio, adjusted for operating expenses. Capital
gain distributions are net profits realized from the sale of portfolio
securities. The performance table and graph do not reflect any taxes that a
shareholder would pay on Fund dividends, capital gain distributions, if any, or
any realized gains on the sale of Fund shares. Total return reflects
reinvestment of the Fund's dividends and capital gain distributions, if any, and
any unrealized gains or losses.
PRICE AND DISTRIBUTION INFORMATION
CLASS A (SYMBOL: FSMIX) CHANGE 9/30/08 9/30/07
- ------------------------------- ------ ------- -------
Net Asset Value (NAV) -$0.62 $8.80 $9.42
DISTRIBUTIONS (10/1/07-9/30/08)
Dividend Income $0.530710
PERFORMANCE(1)
CUMULATIVE TOTAL RETURN EXCLUDES THE SALES CHARGE. AVERAGE ANNUAL TOTAL RETURN
INCLUDES THE MAXIMUM SALES CHARGE. CLASS A: 4.25% MAXIMUM INITIAL SALES CHARGE.
CLASS A 1-YEAR 5-YEAR 10-YEAR
- ------------------------------------- ------ ------- -------
Cumulative Total Return(2) -1.04% +14.17% +57.73%
Average Annual Total Return(3) -5.27% + 1.79% + 4.21%
Distribution Rate(4) 6.02%
30-Day Standardized Yield(5) 4.72%
Total Annual Operating Expenses(6) 0.59%
PERFORMANCE DATA REPRESENT PAST PERFORMANCE, WHICH DOES NOT GUARANTEE FUTURE
RESULTS. INVESTMENT RETURN AND PRINCIPAL VALUE WILL FLUCTUATE, AND YOU MAY HAVE
A GAIN OR LOSS WHEN YOU SELL YOUR SHARES. CURRENT PERFORMANCE MAY DIFFER FROM
FIGURES SHOWN. FOR MOST RECENT MONTH-END PERFORMANCE, SEE "FUNDS AND
PERFORMANCE" AT FRANKLINTEMPLETON.COM OR CALL (800) 342-5236.
Annual Report | 9
Performance Summary (CONTINUED)
TOTAL RETURN INDEX COMPARISON FOR HYPOTHETICAL $10,000 INVESTMENT(1)
Total return represents the change in value of an investment over the periods
shown. It includes the applicable maximum sales charge, Fund expenses, account
fees and reinvested distributions. The unmanaged index includes reinvestment of
any income or distributions. It differs from the Fund in composition and does
not pay management fees or expenses. One cannot invest directly in an index.
AVERAGE ANNUAL TOTAL RETURN
CLASS A 9/30/08
- ------- -------
1-Year -5.27%
5-Year +1.79%
10-Year +4.21%
CLASS A (10/1/98-9/30/08)
(PERFORMANCE GRAPH)
FRANKLIN STRATEGIC MORTGAGE CITIGROUP
DATE PORTFOLIO - CLASS A MORTGAGE INDEX
- ---------- --------------------------- --------------
10/1/1998 $ 9,575 $10,000
10/31/1998 $ 9,577 $ 9,989
11/30/1998 $ 9,636 $10,035
12/31/1998 $ 9,678 $10,086
1/31/1999 $ 9,735 $10,155
2/28/1999 $ 9,687 $10,117
3/31/1999 $ 9,742 $10,187
4/30/1999 $ 9,785 $10,237
5/31/1999 $ 9,720 $10,169
6/30/1999 $ 9,694 $10,145
7/31/1999 $ 9,638 $10,076
8/31/1999 $ 9,631 $10,070
9/30/1999 $ 9,796 $10,241
10/31/1999 $ 9,839 $10,296
11/30/1999 $ 9,847 $10,304
12/31/1999 $ 9,822 $10,271
1/31/2000 $ 9,746 $10,192
2/29/2000 $ 9,855 $10,312
3/31/2000 $ 9,955 $10,422
4/30/2000 $ 9,969 $10,427
5/31/2000 $ 9,978 $10,436
6/30/2000 $10,186 $10,661
7/31/2000 $10,256 $10,729
8/31/2000 $10,414 $10,887
9/30/2000 $10,540 $11,004
10/31/2000 $10,619 $11,085
11/30/2000 $10,780 $11,250
12/31/2000 $10,994 $11,430
1/31/2001 $11,151 $11,607
2/28/2001 $11,216 $11,671
3/31/2001 $11,291 $11,747
4/30/2001 $11,303 $11,760
5/31/2001 $11,367 $11,832
6/30/2001 $11,415 $11,849
7/31/2001 $11,607 $12,070
8/31/2001 $11,706 $12,179
9/30/2001 $11,868 $12,359
10/31/2001 $12,022 $12,527
11/30/2001 $11,948 $12,412
12/31/2001 $11,914 $12,367
1/31/2002 $12,024 $12,489
2/28/2002 $12,142 $12,625
3/31/2002 $12,016 $12,497
4/30/2002 $12,253 $12,730
5/31/2002 $12,339 $12,824
6/30/2002 $12,446 $12,927
7/31/2002 $12,593 $13,073
8/31/2002 $12,686 $13,188
9/30/2002 $12,793 $13,284
10/31/2002 $12,836 $13,334
11/30/2002 $12,832 $13,322
12/31/2002 $12,968 $13,462
1/31/2003 $12,999 $13,501
2/28/2003 $13,078 $13,593
3/31/2003 $13,093 $13,589
4/30/2003 $13,148 $13,640
5/31/2003 $13,179 $13,647
6/30/2003 $13,190 $13,676
7/31/2003 $12,938 $13,429
8/31/2003 $13,021 $13,517
9/30/2003 $13,228 $13,748
10/31/2003 $13,168 $13,701
11/30/2003 $13,210 $13,741
12/31/2003 $13,342 $13,875
1/31/2004 $13,428 $13,963
2/29/2004 $13,555 $14,085
3/31/2004 $13,593 $14,147
4/30/2004 $13,395 $13,898
5/31/2004 $13,369 $13,853
6/30/2004 $13,466 $13,973
7/31/2004 $13,567 $14,105
8/31/2004 $13,794 $14,337
9/30/2004 $13,811 $14,356
10/31/2004 $13,910 $14,479
11/30/2004 $13,875 $14,437
12/31/2004 $13,946 $14,543
1/31/2005 $14,017 $14,617
2/28/2005 $13,976 $14,553
3/31/2005 $13,934 $14,514
4/30/2005 $14,076 $14,686
5/31/2005 $14,195 $14,804
6/30/2005 $14,228 $14,856
7/31/2005 $14,154 $14,785
8/31/2005 $14,290 $14,917
9/30/2005 $14,189 $14,835
10/31/2005 $14,102 $14,740
11/30/2005 $14,147 $14,785
12/31/2005 $14,263 $14,939
1/31/2006 $14,296 $14,975
2/28/2006 $14,356 $15,054
3/31/2006 $14,239 $14,918
4/30/2006 $14,221 $14,921
5/31/2006 $14,197 $14,881
6/30/2006 $14,214 $14,921
7/31/2006 $14,412 $15,143
8/31/2006 $14,597 $15,363
9/30/2006 $14,718 $15,465
10/31/2006 $14,815 $15,581
11/30/2006 $14,970 $15,756
12/31/2006 $14,920 $15,710
1/31/2007 $14,924 $15,724
2/28/2007 $15,095 $15,916
3/31/2007 $15,143 $15,957
4/30/2007 $15,213 $16,032
5/31/2007 $15,115 $15,929
6/30/2007 $15,021 $15,846
7/31/2007 $15,045 $15,951
8/31/2007 $15,080 $16,171
9/30/2007 $15,262 $16,301
10/31/2007 $15,354 $16,461
11/30/2007 $15,490 $16,765
12/31/2007 $15,558 $16,809
1/31/2008 $15,579 $17,122
2/29/2008 $15,369 $17,126
3/31/2008 $15,390 $17,225
4/30/2008 $15,479 $17,227
5/31/2008 $15,485 $17,126
6/30/2008 $15,396 $17,122
7/31/2008 $15,151 $17,091
8/31/2008 $15,088 $17,292
9/30/2008 $15,103 $17,491
ENDNOTES
THE FUND'S SHARE PRICE AND YIELD WILL BE AFFECTED BY INTEREST RATE MOVEMENTS AND
MORTGAGE PREPAYMENTS. BOND PRICES GENERALLY MOVE IN THE OPPOSITE DIRECTION OF
INTEREST RATES. THUS, AS PRICES OF BONDS IN THE FUND ADJUST TO A RISE IN
INTEREST RATES, THE FUND'S SHARE PRICE MAY DECLINE. THE FUND'S PROSPECTUS ALSO
INCLUDES A DESCRIPTION OF THE MAIN INVESTMENT RISKS.
(1.) Past expense reductions by the Fund's manager increased the Fund's total
returns. If the manager had not taken this action, the Fund's total returns
would have been lower.
(2.) Cumulative total return represents the change in value of an investment
over the periods indicated.
(3.) Average annual total return represents the average annual change in value
of an investment over the periods indicated.
(4.) Distribution rate is based on the sum of distributions per share for the 30
days of September and the maximum offering price of $9.19 on 9/30/08.
(5.) Yield, calculated as required by the SEC, is based on the earnings of the
Fund's portfolio for the 30 days ended 9/30/08.
(6.) Figures are as stated in the Fund's prospectus current as of the date of
this report.
(7.) Source: (C) 2008 Morningstar. The Citigroup USBIG Mortgage Index is the
mortgage component of the Citigroup USBIG Bond Index and comprises 30- and
15-year GNMA, FNMA and FHLMC securities, and FNMA and FHLMC balloon
mortgages.
10 | Annual Report
Your Fund's Expenses
As a Fund shareholder, you can incur two types of costs:
- - Transaction costs, including sales charges (loads) on Fund purchases and
redemption fees; and
- - Ongoing Fund costs, including management fees, distribution and service
(12b-1) fees, and other Fund expenses. All mutual funds have ongoing costs,
sometimes referred to as operating expenses.
The following table shows ongoing costs of investing in the Fund and can help
you understand these costs and compare them with those of other mutual funds.
The table assumes a $1,000 investment held for the six months indicated.
ACTUAL FUND EXPENSES
The first line (Actual) for each share class listed in the table provides actual
account values and expenses. The "Ending Account Value" is derived from the
Fund's actual return, which includes the effect of Fund expenses.
You can estimate the expenses you paid during the period by following these
steps. OF COURSE, YOUR ACCOUNT VALUE AND EXPENSES WILL DIFFER FROM THOSE IN THIS
ILLUSTRATION:
1. Divide your account value by $1,000.
IF AN ACCOUNT HAD AN $8,600 VALUE, THEN $8,600 / $1,000 = 8.6.
2. Multiply the result by the number under the heading "Expenses Paid During
Period."
IF EXPENSES PAID DURING PERIOD WERE $7.50, THEN 8.6 X $7.50 = $64.50.
In this illustration, the estimated expenses paid this period are $64.50.
HYPOTHETICAL EXAMPLE FOR COMPARISON WITH OTHER FUNDS
Information in the second line (Hypothetical) for each class in the table can
help you compare ongoing costs of investing in the Fund with those of other
mutual funds. This information may not be used to estimate the actual ending
account balance or expenses you paid during the period. The hypothetical "Ending
Account Value" is based on the actual expense ratio for each class and an
assumed 5% annual rate of return before expenses, which does not represent the
Fund's actual return. The figure under the heading "Expenses Paid During Period"
shows the hypothetical expenses your account would have incurred under this
scenario. You can compare this figure with the 5% hypothetical examples that
appear in shareholder reports of other funds.
Annual Report | 11
Your Fund's Expenses (CONTINUED)
PLEASE NOTE THAT EXPENSES SHOWN IN THE TABLE ARE MEANT TO HIGHLIGHT ONGOING
COSTS AND DO NOT REFLECT ANY TRANSACTION COSTS, SUCH AS SALES CHARGES OR
REDEMPTION FEES. Therefore, the second line for each class is useful in
comparing ongoing costs only, and will not help you compare total costs of
owning different funds. In addition, if transaction costs were included, your
total costs would have been higher. Please refer to the Fund prospectus for
additional information on operating expenses.
BEGINNING ACCOUNT ENDING ACCOUNT EXPENSES PAID DURING
CLASS A VALUE 4/1/08 VALUE 9/30/08 PERIOD* 4/1/08-9/30/08
- ---------------------------------------- ----------------- -------------- ----------------------
Actual $1,000 $ 981.30 $2.82
Hypothetical (5% return before expenses) $1,000 $1,022.15 $2.88
* Expenses are calculated using the most recent six-month annualized expense
ratio of 0.57%, multiplied by the average account value over the period,
multiplied by 183/366 to reflect the one-half year period.
12 | Annual Report
Franklin Strategic Mortgage Portfolio
FINANCIAL HIGHLIGHTS
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
2008 2007 2006 2005 2004
-------- -------- -------- -------- --------
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net asset value, beginning of year .......................... $ 9.42 $ 9.59 $ 9.73 $ 9.96 $ 10.06
-------- -------- -------- -------- --------
Income from investment operations(a):
Net investment income(b) ................................. 0.404 0.476 0.418 0.391 0.328
Net realized and unrealized gains (losses) ............... (0.493) (0.129) (0.069) (0.123) 0.112
-------- -------- -------- -------- --------
Total from investment operations ............................ (0.089) 0.347 0.349 0.268 0.440
-------- -------- -------- -------- --------
Less distributions from net investment income ............... (0.531) (0.517) (0.489) (0.498) 0.540)
-------- -------- -------- -------- --------
Redemption fees(c, d) ....................................... -- -- -- -- --
-------- -------- -------- -------- --------
Net asset value, end of year ................................ $ 8.80 $ 9.42 $ 9.59 $ 9.73 $ 9.96
======== ======== ======== ======== ========
Total return (e) ............................................ (1.04)% 3.70% 3.73% 2.74% 4.41%
RATIOS TO AVERAGE NET ASSETS
Expenses(f) ................................................. 0.57% 0.57% 0.55% 0.55% 0.54%
Net investment income ....................................... 4.58% 5.05% 4.48% 3.97% 3.29%
SUPPLEMENTAL DATA
Net assets, end of year (000's) ............................. $168,674 $243,664 $287,865 $367,759 $376,848
Portfolio turnover rate ..................................... 336.36% 326.67% 247.03% 160.36% 245.18%
Portfolio turnover rate excluding mortgage dollar rolls(g) .. 25.39% 30.85% 38.75% 36.26% 50.14%
(a) The amount shown for a share outstanding throughout the period may not
correlate with the Statement of Operations for the period due to the timing
of sales and repurchases of the Fund shares in relation to income earned
and/or fluctuating market value of the investments of the Fund.
(b) Based on average daily shares outstanding.
(c) Amount rounds to less than $0.001 per share.
(d) Effective September 1, 2008, the redemption fee was eliminated.
(e) Total return does not reflect sales commissions or contingent deferred
sales charges, if applicable.
(f) Benefit of expense reduction rounds to less than 0.01%.
(g) See Note 1(g) regarding mortgage dollar rolls.
The accompanying notes are an integral part of these financial statements.
Annual Report | 13
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008
PRINCIPAL
AMOUNT(a) VALUE
----------- ---------------
MORTGAGE-BACKED SECURITIES 101.2%
(b) FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) ADJUSTABLE RATE 5.1%
FHLMC, 4.875%, 4/01/17 .............................................................. 49,007 $ 49,382
FHLMC, 5.102%, 5/01/22 .............................................................. 63,910 65,195
FHLMC, 5.172%, 5/01/20 .............................................................. 195,584 199,168
FHLMC, 5.295%, 8/01/31 .............................................................. 49,928 50,107
FHLMC, 5.336%, 11/01/16 ............................................................. 384,323 389,678
FHLMC, 5.361%, 3/01/19 .............................................................. 211,256 215,171
FHLMC, 5.375%, 4/01/18 .............................................................. 96,728 97,757
FHLMC, 5.428%, 7/01/22 .............................................................. 1,195,473 1,210,304
FHLMC, 5.525%, 11/01/25 ............................................................. 95,743 96,533
FHLMC, 5.962%, 10/01/36 ............................................................. 2,696,923 2,745,481
FHLMC, 5.979%, 10/01/18 ............................................................. 179,927 182,896
FHLMC, 6.059%, 4/01/31 .............................................................. 68,582 70,524
FHLMC, 6.077%, 1/01/31 .............................................................. 186,711 190,658
FHLMC, 6.126%, 12/01/30 ............................................................. 117,882 120,354
FHLMC, 6.168%, 7/01/30 .............................................................. 551,924 571,878
FHLMC, 6.434%, 1/01/32 .............................................................. 125,259 126,963
FHLMC, 6.496%, 4/01/24 .............................................................. 208,223 212,539
FHLMC, 6.551%, 1/01/28 .............................................................. 310,856 315,803
FHLMC, 6.745%, 7/01/24 .............................................................. 149,400 152,509
FHLMC, 6.831%, 4/01/30 .............................................................. 1,305,139 1,339,206
FHLMC, 6.887%, 11/01/19 ............................................................. 167,455 172,494
---------------
8,574,600
---------------
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) FIXED RATE 32.2%
FHLMC Gold 15 Year, 6.50%, 3/01/09 - 4/01/11 ........................................ 707 725
FHLMC Gold 15 Year, 7.00%, 6/01/09 - 7/01/11 ........................................ 1,803 1,876
FHLMC Gold 15 Year, 7.50%, 4/01/10 .................................................. 969 1,004
FHLMC Gold 15 Year, 8.00%, 1/01/10 - 12/01/12 ....................................... 12,960 13,292
FHLMC Gold 30 Year, 5.00%, 10/01/33 - 7/01/35 ....................................... 2,894,139 2,825,201
FHLMC Gold 30 Year, 5.00%, 7/01/35 .................................................. 1,967,555 1,919,978
FHLMC Gold 30 Year, 5.00%, 7/01/35 .................................................. 3,457,772 3,374,160
FHLMC Gold 30 Year, 5.00%, 7/01/35 .................................................. 3,627,327 3,539,615
(c) FHLMC Gold 30 Year, 5.00%, 10/15/35 ................................................. 2,688,000 2,618,701
FHLMC Gold 30 Year, 5.50%, 9/01/33 .................................................. 462,290 461,286
(c) FHLMC Gold 30 Year, 5.50%, 10/15/35 ................................................. 11,860,000 11,798,850
FHLMC Gold 30 Year, 6.00%, 7/01/28 - 6/01/34 ........................................ 579,230 589,120
(c) FHLMC Gold 30 Year, 6.00%, 10/01/30 ................................................. 13,400,000 13,565,410
FHLMC Gold 30 Year, 6.00%, 8/01/34 .................................................. 3,622,296 3,678,774
FHLMC Gold 30 Year, 6.50%, 2/01/19 - 7/01/32 ........................................ 1,421,449 1,473,065
(c) FHLMC Gold 30 Year, 6.50%, 10/01/32 ................................................. 4,250,000 4,358,243
FHLMC Gold 30 Year, 7.50%, 10/01/25 - 8/01/32 ....................................... 849,205 917,320
FHLMC Gold 30 Year, 8.00%, 7/01/24 - 5/01/30 ........................................ 173,255 187,793
FHLMC Gold 30 Year, 8.50%, 10/01/17 - 9/01/30 ....................................... 371,445 399,843
FHLMC Gold 30 Year, 9.00%, 9/01/30 .................................................. 256,907 286,126
FHLMC Gold 30 Year, 9.25%, 12/01/08 ................................................. 35 35
FHLMC Gold 30 Year, 9.50%, 12/01/16 - 4/01/25 ....................................... 1,025,092 1,145,423
FHLMC PC 30 Year, 8.50%, 2/01/17 - 5/01/17 .......................................... 896,051 972,067
FHLMC PC 30 Year, 9.00%, 6/01/16 .................................................... 1,632 1,790
14 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
----------- ---------------
MORTGAGE-BACKED SECURITIES (CONTINUED)
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) FIXED RATE (CONTINUED)
FHLMC PC 30 Year, 9.25%, 8/01/14 .................................................... 4,169 $ 4,536
FHLMC PC 30 Year, 9.50%, 12/01/09 - 8/01/19 ......................................... 127,064 139,325
---------------
54,273,558
---------------
(b) FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) ADJUSTABLE RATE 6.3%
FNMA, 3.704%, 1/01/17 ............................................................... 642,816 649,911
FNMA, 4.079%, 1/01/18 ............................................................... 2,095,265 2,092,776
FNMA, 4.425%, 5/01/30 ............................................................... 191,881 195,169
FNMA, 4.605%, 4/01/31 ............................................................... 74,640 74,994
FNMA, 4.812%, 4/01/21 ............................................................... 33,923 33,786
FNMA, 5.00%, 11/01/28 ............................................................... 134,812 137,086
FNMA, 5.02%, 7/01/27 ................................................................ 141,609 143,951
FNMA, 5.049%, 7/01/31 ............................................................... 5,547 5,705
FNMA, 5.061%, 12/01/22 .............................................................. 184,346 187,044
FNMA, 5.17%, 4/01/18 ................................................................ 32,759 32,751
FNMA, 5.203%, 11/01/31 .............................................................. 427,506 440,619
FNMA, 5.215%, 5/01/31 ............................................................... 28,723 29,507
FNMA, 5.248%, 4/01/33 ............................................................... 476,453 486,100
FNMA, 5.257%, 8/01/29 ............................................................... 57,201 58,136
FNMA, 5.26%, 10/01/19 ............................................................... 294,290 297,587
FNMA, 5.275%, 6/01/31 ............................................................... 375,428 378,243
FNMA, 5.288%, 2/01/32 ............................................................... 156,081 158,140
FNMA, 5.312%, 7/01/17 ............................................................... 148,021 151,047
FNMA, 5.396%, 4/01/27 ............................................................... 184,936 187,905
FNMA, 5.449%, 9/01/32 ............................................................... 439,132 447,103
FNMA, 5.511%, 5/01/21 ............................................................... 308,137 315,749
FNMA, 5.52%, 7/01/26 ................................................................ 44,004 43,875
FNMA, 5.522%, 7/01/14 ............................................................... 293,998 296,288
FNMA, 5.651%, 7/01/19 ............................................................... 1,212,716 1,228,887
FNMA, 5.658%, 12/01/24 .............................................................. 108,800 112,091
FNMA, 5.852%, 10/01/32 .............................................................. 267,227 270,851
FNMA, 6.028%, 8/01/27 ............................................................... 162,618 163,984
FNMA, 6.122%, 7/01/25 ............................................................... 78,428 79,259
FNMA, 6.322%, 7/01/31 ............................................................... 891,954 926,691
FNMA, 6.341%, 6/01/17 ............................................................... 96,400 96,756
FNMA, 6.375%, 10/01/29 .............................................................. 25,396 25,945
FNMA, 6.382%, 8/01/26 ............................................................... 140,682 144,894
FNMA, 6.402%, 12/01/31 .............................................................. 74,233 75,576
FNMA, 6.444%, 4/01/18 ............................................................... 188,097 193,234
FNMA, 6.496%, 10/01/24 .............................................................. 337,858 344,713
FNMA, 6.875%, 9/01/18 ............................................................... 51,037 51,793
FNMA, 6.945%, 5/01/27 ............................................................... 114,601 115,992
---------------
10,674,138
---------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE 50.8%
FNMA 15 Year, 5.00%, 6/01/18 ........................................................ 866,751 869,738
FNMA 15 Year, 5.00%, 7/01/18 ........................................................ 3,344,726 3,360,435
FNMA 15 Year, 5.50%, 5/01/14 - 2/01/18 .............................................. 3,221,396 3,280,966
FNMA 15 Year, 6.50%, 4/01/11 - 10/01/16 ............................................. 258,974 269,281
Annual Report | 15
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
----------- ---------------
MORTGAGE-BACKED SECURITIES (CONTINUED)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE (CONTINUED)
FNMA 15 Year, 7.00%, 11/01/11 ....................................................... 598 $ 626
FNMA 15 Year, 7.50%, 7/01/09 - 7/01/12 .............................................. 21,505 22,489
FNMA 15 Year, 9.00%, 11/01/11 ....................................................... 83,417 87,402
FNMA 30 Year, 5.00%, 4/01/34 ........................................................ 1,232,358 1,203,715
(c) FNMA 30 Year, 5.00%, 10/25/35 ....................................................... 12,600,000 12,279,091
FNMA 30 Year, 5.50%, 9/01/33 - 11/01/35 ............................................. 8,775,475 8,776,267
(c) FNMA 30 Year, 5.50%, 10/15/34 ....................................................... 5,600,000 5,585,126
FNMA 30 Year, 5.50%, 11/01/34 ....................................................... 15,021,979 15,012,803
FNMA 30 Year, 6.00%, 12/01/23 - 12/01/35 ............................................ 8,286,339 8,424,464
(c) FNMA 30 Year, 6.00%, 10/01/28 ....................................................... 8,600,000 8,711,533
FNMA 30 Year, 6.00%, 10/01/34 ....................................................... 4,566,938 4,640,999
FNMA 30 Year, 6.00%, 11/01/34 ....................................................... 1,811,950 1,841,334
FNMA 30 Year, 6.50%, 12/01/27 - 8/01/32 ............................................. 6,679,465 6,906,651
(c) FNMA 30 Year, 6.50%, 10/01/29 ....................................................... 2,000,000 2,050,938
FNMA 30 Year, 7.50%, 8/01/25 - 5/01/32 .............................................. 367,113 396,718
FNMA 30 Year, 8.00%, 1/01/25 - 7/01/31 .............................................. 68,214 73,938
FNMA 30 Year, 8.50%, 11/01/26 - 11/01/28 ............................................ 886,782 976,144
FNMA 30 Year, 9.00%, 2/01/11 - 9/01/26 .............................................. 181,294 192,664
FNMA 30 Year, 9.50%, 11/01/15 - 4/01/30 ............................................. 266,520 294,132
FNMA 30 Year, 10.00%, 8/01/15 - 4/01/21 ............................................. 284,221 322,618
FNMA 30 Year, 10.50%, 1/01/16 - 5/01/30 ............................................. 21,651 24,120
FNMA 30 Year, 11.00%, 10/01/15 ...................................................... 10,405 11,279
FNMA 30 Year, 12.00%, 4/01/15 - 5/01/16 ............................................. 3,194 3,621
FNMA 30 Year, 12.50%, 12/01/13 ...................................................... 643 747
---------------
85,619,839
---------------
(b) GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) ADJUSTABLE RATE 0.2%
GNMA, 5.125%, 11/20/25 .............................................................. 75,277 76,213
GNMA, 5.625%, 7/20/27 ............................................................... 218,577 221,173
---------------
297,386
---------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) FIXED RATE 6.6%
GNMA I SF 15 Year, 7.00%, 4/15/14 ................................................... 30,040 31,678
GNMA I SF 15 Year, 8.00%, 9/15/15 ................................................... 28,084 30,089
(c) GNMA I SF 30 Year, 6.00%, 10/15/31 .................................................. 6,500,000 6,596,486
GNMA I SF 30 Year, 6.50%, 1/15/24 - 9/15/32 ......................................... 663,462 683,020
GNMA I SF 30 Year, 7.00%, 3/15/17 - 2/15/32 ......................................... 610,888 645,005
GNMA I SF 30 Year, 7.50%, 10/15/23 - 10/15/29 ....................................... 91,387 98,653
GNMA I SF 30 Year, 8.00%, 1/15/17 - 9/15/27 ......................................... 339,336 371,146
GNMA I SF 30 Year, 8.25%, 1/15/21 - 5/15/21 ......................................... 198,721 218,230
GNMA I SF 30 Year, 8.50%, 6/15/16 - 7/15/24 ......................................... 432,229 476,665
GNMA I SF 30 Year, 9.00%, 1/15/09 - 8/15/28 ......................................... 72,442 79,097
GNMA I SF 30 Year, 9.50%, 10/15/09 - 1/15/10 ........................................ 37,447 38,883
GNMA I SF 30 Year, 10.00%, 10/15/18 - 2/15/19 ....................................... 9,299 10,629
GNMA I SF 30 Year, 10.50%, 1/15/16 .................................................. 995 1,139
GNMA II SF 30 Year, 6.50%, 1/20/26 - 2/20/34 ........................................ 1,027,091 1,055,348
GNMA II SF 30 Year, 7.50%, 11/20/22 - 7/20/32 ....................................... 552,442 593,467
GNMA II SF 30 Year, 8.00%, 1/20/17 - 8/20/26 ........................................ 165,619 180,085
16 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
----------- ---------------
MORTGAGE-BACKED SECURITIES (CONTINUED)
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) FIXED RATE (CONTINUED)
GNMA II SF 30 Year, 8.50%, 7/20/16 - 8/20/16 ........................................ 74,254 $ 81,137
GNMA II SF 30 Year, 9.00%, 11/20/19 - 3/20/25 ....................................... 7,322 8,039
GNMA II SF 30 Year, 10.50%, 6/20/20 ................................................. 26 31
---------------
11,198,827
---------------
TOTAL MORTGAGE-BACKED SECURITIES (COST $172,178,875) ................................ 170,638,348
---------------
ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED
SECURITIES 33.3%
FINANCE 33.3%
(b) ACE Securities Corp., 2004-HE4, M9, 6.306%, 12/25/34 ................................ 947,011 17,297
(b) AFC Home Equity Loan Trust, 1997-4, 2A2, 3.847%, 12/22/27 ........................... 428,693 276,928
(b, d) Ameriquest Mortgage Securities Inc., 2003-12, M2, 4.907%, 1/25/34 ................... 1,350,752 882,421
(b) Asset-Backed Securities Corp. Home Equity Loan Trust,
2005-HE4, A1, 3.367%, 5/25/35..................................................... 70,325 67,285
(b, e) Bayview Commercial Asset Trust, 2006-CD1A, A-1, 144A, 3.573%, 7/25/23 (Canada) ...... 1,582,452 CAD 1,479,282
Bear Stearns Commercial Mortgage Securities Inc.,
2005-PW10, A4, 5.405%, 12/11/40 .................................................. 3,000,000 2,772,292
(b, e) 2007-T26, B, 144A, 5.60%, 1/12/45 ................................................ 2,650,000 1,482,660
CitiFinancial Mortgage Securities Inc., 2003-4, AF6, 4.493%, 10/25/33 ............... 2,062,540 1,830,592
Citigroup/Deutsche Bank Commercial Mortgage Trust,
2006-CD3, A5, 5.617%, 10/15/48 ................................................... 7,000,000 6,233,185
2007-CD4, C, 5.476%, 12/11/49 .................................................... 6,500,000 3,174,587
(b) Contimortgage Home Equity Loan Trust, 1999-3, A6, 8.18%, 12/25/29 ................... 46,232 45,291
Countrywide Asset-Backed Certificates,
2004-7, AF4, 4.774%, 8/25/32 ..................................................... 889,298 872,971
(b) 2006-11, 1AF1, 3.327%, 9/25/46 ................................................... 466,879 457,658
(b) FHLMC, 2942, TF, 2.838%, 3/15/35 .................................................... 1,425,962 1,396,596
(b) First Franklin Mortgage Loan Asset-Backed Certificates,
2004-FF11, 1A2, 3.557%, 1/25/35 .................................................. 280,716 208,656
2006-FF12, A2, 3.247%, 9/25/36 ................................................... 974,846 950,745
FNMA,
(b) 2007-1, NF, 3.457%, 2/25/37 ...................................................... 1,029,083 997,581
G93-33, K, 7.00%, 9/25/23 ........................................................ 1,857,650 1,947,641
GE Capital Commercial Mortgage Corp., 2003-C1, A4, 4.819%, 1/10/38 .................. 1,262,683 1,182,784
Greenwich Capital Commercial Funding Corp.,
2004-GG1, A7, 5.317%, 6/10/36 .................................................... 5,000,000 4,719,363
2007-GG9, C, 5.554%, 3/10/39 ..................................................... 3,500,000 2,085,011
(b) HSI Asset Securitization Corp. Trust, 2006-OPT4, 2A2, 3.317%, 3/25/36 ............... 820,677 807,456
JPMorgan Chase Commercial Mortgage Securities Corp.,
(b) 2004-CB9, A4, 5.372%, 6/12/41 .................................................... 3,779,632 3,556,453
2004-LN2, A2, 5.115%, 7/15/41 .................................................... 557,685 514,201
LB-UBS Commercial Mortgage Trust, 2007-C2, C, 5.611%, 2/15/40 ....................... 6,100,000 3,625,416
(b) Master Asset-Backed Securities Trust, 2006-AB1, A1, 3.347%, 2/25/36 ................. 738,702 729,583
(b) Merrill Lynch Mortgage Investors Trust, 2006-RM2, A1B, 3.442%, 5/25/37 .............. 4,216,803 1,497,028
(b) Morgan Stanley ABS Capital I Inc. Trust, 2006-NC3, A2B, 3.327%, 3/25/36 ............. 1,496,884 1,464,352
(b) Morgan Stanley Capital I Trust, 2004-IQ7, A4, 5.404%, 6/15/38 ....................... 6,000,000 5,663,817
(b) Novastar Home Equity Loan, 2004-4, M4, 4.307%, 3/25/35 .............................. 1,500,000 1,066,727
(b) Ownit Mortgage Loan Asset-Backed Certificates, 2006-6, A2B, 3.317%, 9/25/37 ......... 2,000,000 1,787,524
Annual Report | 17
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
----------- ---------------
ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES (CONTINUED)
FINANCE (CONTINUED)
Residential Asset Securities Corp.,
2004-KS1, AI4, 4.213%, 4/25/32 ................................................... 929,656 $ 905,590
(b) 2005-AHL2, A2, 3.467%, 10/25/35 .................................................. 192,880 177,612
Residential Funding Mortgage Securities II,
2004-HI2, A4, 5.24%, 9/25/18 ..................................................... 406,045 399,665
(b) 2006-HI1, A1, 3.317%, 2/25/36 .................................................... 41,439 41,197
(b) Structured Asset Investment Loan Trust, 2004-1, M5, 7.707%, 2/25/34 ................. 434,772 37,977
(b, e) Structured Asset Securities Corp., 2005-SC1, 1A1, 144A, 3.477%, 5/25/31 ............. 803,101 649,222
(b) Travelers Mortgage Services Inc., 1998-5A, A, 6.606%, 12/25/18 ...................... 111,490 90,307
Vanderbilt Mortgage Finance, 1998-C, 1A6, 6.75%, 10/07/28 ........................... 100,000 99,230
---------------
TOTAL ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES
(COST $73,375,994) ............................................................... 56,194,183
---------------
TOTAL INVESTMENTS BEFORE SHORT TERM INVESTMENTS (COST $245,554,869) ................. 226,832,531
---------------
SHORT TERM INVESTMENTS 5.9%
U.S. GOVERNMENT AND AGENCY SECURITIES (COST $199,467) 0.1%
(f, g) U.S. Treasury Bill, 11/28/08 ........................................................ 200,000 199,742
---------------
SHARES
-----------
MONEY MARKET FUNDS (COST $8,528,697) 5.1%
(h) Franklin Institutional Fiduciary Trust Money Market Portfolio, 1.98% ................ 8,528,697 8,528,697
---------------
PRINCIPAL
AMOUNT(a)
-----------
REPURCHASE AGREEMENTS (COST $1,237,470) 0.7%
(i) Joint Repurchase Agreement, 1.347%, 10/01/08 (Maturity Value $1,237,516) ............ 1,237,470 1,237,470
ABN AMRO Bank NV, New York Branch (Maturity Value $195,787)
Banc of America Securities LLC (Maturity Value $152,710)
Barclays Capital Inc. (Maturity Value $197,743)
BNP Paribas Securities Corp. (Maturity Value $191,865)
Credit Suisse Securities (USA) LLC (Maturity Value $39,155)
Deutsche Bank Securities Inc. (Maturity Value $72,605)
Dresdner Kleinwort Securities LLC (Maturity Value $146,843)
Greenwich Capital Markets Inc. (Maturity Value $201,653)
UBS Securities LLC (Maturity Value $39,155)
Collateralized by U.S. Government Agency Securities, 2.20% - 7.25%,
11/07/08 - 4/24/13;
(f) U.S. Government Agency Discount Notes, 12/30/08; and U.S. Treasury Notes,
1.875% - 4.875%, 1/15/09 - 7/31/13
---------------
TOTAL INVESTMENTS (COST $255,520,503) 140.4% ........................................ 236,798,440
OTHER ASSETS, LESS LIABILITIES (40.4)% .............................................. (68,124,070)
---------------
NET ASSETS 100.0% ................................................................... $ 168,674,370
===============
18 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2008 (CONTINUED)
CURRENCY ABBREVIATIONS
CAD - Canadian Dollar
SELECTED PORTFOLIO ABBREVIATIONS
PC - Participation Certificate
SF - Single Family
(a) The principal amount is stated in U.S. dollars unless otherwise indicated.
(b) The coupon rate shown represents the rate at period end.
(c) A portion or all of the security purchased on a TBA basis. See Note 1(d).
(d) Security has been deemed illiquid because it may not be sold within seven
days. At September 30, 2008, the aggregate value of this security was
$882,421, representing 0.52% of net assets.
(e) Security was purchased pursuant to Rule 144A under the Securities Act of
1933 and may be sold in transactions exempt from registration only to
qualified institutional buyers or in a public offering registered under the
Securities Act of 1933. These securities have been deemed liquid under
guidelines approved by the Trust's Board of Trustees. At September 30,
2008, the aggregate value of these securities was $3,611,164, representing
2.14% of net assets.
(f) The security is traded on a discount basis with no stated coupon rate.
(g) Security or a portion of the security has been segregated as collateral for
open financial futures contracts. At September 30, 2008, the value of
securities and or cash pledged amounted to $199,742.
(h) See Note 7 regarding investments in the Franklin Institutional Fiduciary
Trust Money Market Portfolio. The rate shown is the annualized seven-day
yield at period end.
(i) See Note 1(c) regarding joint repurchase agreement.
The accompanying notes are an integral part of these financial statements.
Annual Report | 19
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS
STATEMENT OF ASSETS AND LIABILITIES
September 30, 2008
Assets:
Investments in securities:
Cost - Unaffiliated issuers ......................................... $245,754,336
Cost - Sweep Money Fund (Note 7) .................................... 8,528,697
Cost - Repurchase agreements ........................................ 1,237,470
------------
Total cost of investments ........................................... $255,520,503
============
Value - Unaffiliated issuers ........................................ $227,032,273
Value - Sweep Money Fund (Note 7) ................................... 8,528,697
Value - Repurchase agreements ....................................... 1,237,470
------------
Total value of investments .......................................... 236,798,440
Receivables:
Investment securities sold .......................................... 32,359,949
Capital shares sold ................................................. 54,735
Interest ............................................................ 762,326
Variation margin .................................................... 225,781
------------
Total assets ..................................................... 270,201,231
------------
Liabilities:
Payables:
Investment securities purchased ..................................... 100,561,863
Capital shares redeemed ............................................. 667,211
Affiliates .......................................................... 64,072
Distributions to shareholders ....................................... 152,283
Accrued expenses and other liabilities ................................. 81,432
------------
Total liabilities ................................................ 101,526,861
------------
Net assets, at value .......................................... $168,674,370
============
Net assets consist of:
Paid-in capital ........................................................ $208,882,565
Distributions in excess of net investment income ....................... (94,425)
Net unrealized appreciation (depreciation) ............................. (18,657,867)
Accumulated net realized gain (loss) ................................... (21,455,903)
------------
Net assets, at value .......................................... $168,674,370
============
Shares outstanding ..................................................... 19,162,848
============
Net asset value per share (a) .......................................... $ 8.80
============
Maximum offering price per share (net asset value per share / 95.75%) .. $ 9.19
============
(a) Redemption price is equal to net asset value less contingent deferred sales
charges, if applicable.
The accompanying notes are an integral part of these financial statements.
20 | Annual Report
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS (CONTINUED)
STATEMENT OF OPERATIONS
for the year ended September 30, 2008
Investment income:
Dividends from Sweep Money Fund (Note 7) ............................... $ 215,797
Interest ............................................................... 10,390,992
------------
Total investment income .......................................... 10,606,789
------------
Expenses:
Management fees (Note 3a) .............................................. 797,922
Transfer agent fees (Note 3d) .......................................... 216,561
Custodian fees (Note 4) ................................................ 5,874
Reports to shareholders ................................................ 39,558
Registration and filing fees ........................................... 36,571
Professional fees ...................................................... 48,787
Trustees' fees and expenses ............................................ 13,780
Other .................................................................. 23,233
------------
Total expenses ................................................... 1,182,286
Expense reductions (Note 4) ...................................... (592)
------------
Net expenses .................................................. 1,181,694
------------
Net investment income ...................................... 9,425,095
------------
Realized and unrealized gains (losses):
Net realized gain (loss) from:
Investments ......................................................... 2,135,402
Foreign currency transactions ....................................... 18,061
Financial futures contracts ......................................... (1,344,259)
------------
Net realized gain (loss) ................................... 809,204
------------
Net change in unrealized appreciation (depreciation) on:
Investments ......................................................... (11,610,989)
Translation of other assets and liabilities denominated in foreign
currencies ....................................................... (11,472)
------------
Net change in unrealized appreciation (depreciation) ....... (11,622,461)
------------
Net realized and unrealized gain (loss) ................................... (10,813,257)
------------
Net increase (decrease) in net assets resulting from operations ........... $ (1,388,162)
============
The accompanying notes are an integral part of these financial statements.
Annual Report | 21
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS (CONTINUED)
STATEMENTS OF CHANGES IN NET ASSETS
YEAR ENDED SEPTEMBER 30,
---------------------------
2008 2007
------------ ------------
Increase (decrease) in net assets:
Operations:
Net investment income ............................................... $ 9,425,095 $ 13,719,643
Net realized gain (loss) from investments, foreign currency
transactions and financial futures contracts ..................... 809,204 (1,286,310)
Net change in unrealized appreciation (depreciation) on investments
and translation of other assets and liabilities denominated in
foreign currencies ............................................... (11,622,461) (2,558,371)
------------ ------------
Net increase (decrease) in net assets resulting from operations .. (1,388,162) 9,874,962
------------ ------------
Distributions to shareholders from net investment income ............... (11,828,294) (14,759,374)
Capital share transactions (Note 2) .................................... (61,774,422) (39,317,503)
Redemption fees ........................................................ 1,432 1,009
------------ ------------
Net increase (decrease) in net assets ............................ (74,989,446) (44,200,906)
Net assets:
Beginning of year ...................................................... 243,663,816 287,864,722
------------ ------------
End of year ............................................................ $168,674,370 $243,663,816
============ ============
Distributions in excess of net investment income included in net assets:
End of year ............................................................ $ (94,425) $ (120,565)
============ ============
The accompanying notes are an integral part of these financial statements.
22 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Franklin Strategic Mortgage Portfolio (Trust) is registered under the Investment
Company Act of 1940, as amended, (1940 Act) as a diversified, open-end
investment company, consisting of one fund, the Franklin Strategic Mortgage
Portfolio (Fund).
The following summarizes the Fund's significant accounting policies.
A. SECURITY VALUATION
Securities listed on a securities exchange or on the NASDAQ National Market
System are valued at the last quoted sale price or the official closing price of
the day, respectively. Over-the-counter securities and listed securities for
which there is no reported sale are valued within the range of the most recent
quoted bid and ask prices. Securities that trade in multiple markets or on
multiple exchanges are valued according to the broadest and most representative
market. Investments in open-end mutual funds are valued at the closing net asset
value.
Government securities, mortgage pass-through securities, other mortgage-backed
securities, collateralized mortgage obligations and asset-backed securities
generally trade in the over-the-counter market rather than on a securities
exchange. The Fund may utilize independent pricing services, quotations from
bond dealers, and information with respect to bond and note transactions, to
assist in determining a current market value for each security. The Fund's
pricing services may use valuation models or matrix pricing which considers
information with respect to comparable bond and note transactions, quotations
from bond dealers, or by reference to other securities that are considered
comparable in such characteristics as rating, interest rate and maturity date,
option adjusted spread models, prepayment projections, interest rate spreads and
yield curves, to determine current value.
The Trust has procedures to determine the fair value of individual securities
and other assets for which market prices are not readily available or which may
not be reliably priced. Methods for valuing these securities may include:
fundamental analysis, matrix pricing, discounts from market prices of similar
securities, or discounts applied due to the nature and duration of restrictions
on the disposition of the securities. Due to the inherent uncertainty of
valuations of such securities, the fair values may differ significantly from the
values that would have been used had a ready market for such investments
existed. Occasionally, events occur between the time at which trading in a
security is completed and the close of the NYSE that might call into question
the availability (including the reliability) of the value of a portfolio
security held by the Fund. If such an event occurs, the securities may be valued
using fair value procedures, which may include the use of independent pricing
services. All security valuation procedures are approved by the Trust's Board of
Trustees.
B. FOREIGN CURRENCY TRANSLATION
Portfolio securities and other assets and liabilities denominated in foreign
currencies are translated into U.S. dollars based on the exchange rate of such
currencies against U.S. dollars on the
Annual Report | 23
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
B. FOREIGN CURRENCY TRANSLATION (CONTINUED)
date of valuation. Purchases and sales of securities, income and expense items
denominated in foreign currencies are translated into U.S. dollars at the
exchange rate in effect on the transaction date. Occasionally, events may impact
the availability or reliability of foreign exchange rates used to convert the
U.S. dollar equivalent value. If such an event occurs, the foreign exchange rate
will be valued at fair value using procedures established and approved by the
Trust's Board of Trustees.
The Fund does not separately report the effect of changes in foreign exchange
rates from changes in market prices on securities held. Such changes are
included in net realized and unrealized gain or loss from investments on the
Statement of Operations.
Realized foreign exchange gains or losses arise from sales of foreign
currencies, currency gains or losses realized between the trade and settlement
dates on securities transactions and the difference between the recorded amounts
of dividends, interest, and foreign withholding taxes and the U.S. dollar
equivalent of the amounts actually received or paid. Net unrealized foreign
exchange gains and losses arise from changes in foreign exchange rates on
foreign denominated assets and liabilities other than investments in securities
held at the end of the reporting period.
C. JOINT REPURCHASE AGREEMENT
The Fund may enter into a joint repurchase agreement whereby its uninvested cash
balance is deposited into a joint cash account with other funds managed by the
investment manager or an affiliate of the investment manager and is used to
invest in one or more repurchase agreements. The value and face amount of the
joint repurchase agreement are allocated to the funds based on their 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%. The joint repurchase agreement held by
the Fund at year end had been entered into on September 30, 2008. The joint
repurchase agreement is valued at cost.
D. SECURITIES PURCHASED ON A TBA BASIS
The Fund may purchase securities on a to-be-announced (TBA) basis, with payment
and delivery scheduled for a future date. These transactions are subject to
market fluctuations and are subject to the risk that the value at delivery may
be more or less than the trade date purchase price. Although the Fund will
generally purchase these securities with the intention of holding the
securities, it may sell the securities before the settlement date. Sufficient
assets have been segregated for these securities.
24 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
E. FUTURES CONTRACTS
The Fund may purchase financial futures contracts to gain exposure to market
changes. A financial futures contract is an agreement between two parties to buy
or sell a security for a set price on a future date. Required initial margin
deposits of cash or securities are maintained by the counterparty in segregated
accounts as disclosed in the Statement of Investments. Subsequent payments,
known as variation margin, are made or received by the fund depending on the
fluctuations in the value of the underlying securities. Such variation margin is
accounted for as unrealized gains or losses until the contract is closed, at
which time the gains or losses are reclassified to realized. Realized and
unrealized gains and losses on these contracts are included in the Statement of
Operations.
The risks of these contracts include the possibility there may be an illiquid
secondary market and/or a change in the value of the contract may not correlate
with the changes in the value of the underlying securities.
F. FOREIGN CURRENCY CONTRACTS
When the Fund purchases or sells foreign securities it may enter into foreign
exchange contracts to minimize foreign exchange risk from the trade date to the
settlement date of the transactions. A foreign exchange contract is an agreement
between two parties to exchange different currencies at an agreed upon exchange
rate at a future date. Realized and unrealized gains and losses on these
contracts are included in the Statement of Operations.
The risks of these contracts include movement in the values of the foreign
currencies relative to the U.S. dollar and the possible inability of the
counterparties to fulfill their obligations under the contracts, which may be in
excess of the amount reflected in the Statement of Assets and Liabilities.
G. MORTGAGE DOLLAR ROLLS
The Fund may enter into mortgage dollar rolls, typically on a TBA basis.
Mortgage dollar rolls are agreements between the Fund and a financial
institution to simultaneously sell and repurchase mortgage-backed securities at
a future date. Gains or losses are realized on the initial sale, and the
difference between the repurchase price and the sale price is recorded as an
unrealized gain or loss to the Fund upon entering into the mortgage dollar roll.
In addition, the Fund may earn interest on the cash proceeds that are received
from the initial sale. During the period between the sale and repurchase, the
Fund is not entitled to principal and interest paid on the mortgage backed
securities. The risks of mortgage dollar roll transactions include the potential
inability of the counterparty to fulfill its obligations.
Annual Report | 25
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
H. INCOME TAXES
No provision has been made for U.S. income taxes because it is the Fund's policy
to qualify as a regulated investment company under the Internal Revenue Code and
to distribute to shareholders substantially all of its taxable income and net
realized gains.
The Fund has reviewed the tax positions, taken on federal income tax returns,
for each of the three open tax years and as of September 30, 2008, and has
determined that no provision for income tax is required in the Fund's financial
statements.
I. 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. Distributions to shareholders are recorded on the ex-dividend date
and are determined according to income tax regulations (tax basis).
Distributable earnings determined on a tax basis may differ from earnings
recorded in accordance with accounting principles generally accepted in the
United States of America. These differences may be permanent or temporary.
Permanent differences are reclassified among capital accounts to reflect their
tax character. These reclassifications have no impact on net assets or the
results of operations. Temporary differences are not reclassified, as they may
reverse in subsequent periods.
J. ACCOUNTING ESTIMATES
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States of America 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 expenses during the reporting period. Actual results could differ from those
estimates.
K. REDEMPTION FEES
A short term trading redemption fee was imposed, with some exceptions, on any
fund shares that were redeemed or exchanged within seven calendar days following
their purchase date. The redemption fee was 2% of the amount redeemed. Such fees
were retained by the fund and accounted for as an addition to paid-in capital.
Effective September 1, 2008, the redemption fee was eliminated.
26 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
L. GUARANTEES AND INDEMNIFICATIONS
Under the Fund's organizational documents, its officers and trustees are
indemnified by the Fund against certain liabilities arising out of the
performance of their duties to the Fund. Additionally, in the normal course of
business, the Fund enters into contracts with service providers that contain
general indemnification clauses. The Fund's maximum exposure under these
arrangements is unknown as this would involve future claims that may be made
against the Fund that have not yet occurred. Currently, the Fund expects the
risk of loss to be remote.
2. SHARES OF BENEFICIAL INTEREST
At September 30, 2008, there were an unlimited number of shares authorized
(without par value). Transactions in the Fund's shares were as follows:
YEAR ENDED SEPTEMBER 30,
-----------------------------------------------------
2008 2007
------------------------- -------------------------
SHARES AMOUNT SHARES AMOUNT
---------- ------------ ---------- ------------
Shares sold .................... 1,571,128 $ 14,491,454 3,029,951 $ 28,938,366
Shares issued in reinvestment
of distributions ............ 1,079,811 9,945,846 1,296,189 12,353,213
Shares redeemed ................ (9,359,274) (86,211,722) (8,476,807) (80,609,082)
---------- ------------ ---------- ------------
Net increase (decrease) ........ (6,708,335) $(61,774,422) (4,150,667) $(39,317,503)
========== ============ ========== ============
3. TRANSACTIONS WITH AFFILIATES
Franklin Resources, Inc. is the holding company for various subsidiaries that
together are referred to as Franklin Templeton Investments. Certain officers and
trustees of the Trust are also officers and/or directors of the following
subsidiaries:
SUBSIDIARY AFFILIATION
- ---------- ----------------------
Franklin Advisers, Inc. (Advisers) Investment manager
Franklin Templeton Services, LLC (FT Services) Administrative manager
Franklin Templeton Distributors, Inc. (Distributors) Principal underwriter
Franklin Templeton Investor Services, LLC (Investor Services) Transfer agent
A. MANAGEMENT FEES
The Fund pays an investment management fee to Advisers based on the average
daily net assets of the Fund as follows:
ANNUALIZED FEE RATE NET ASSETS
- ------------------- ---------------------------------------------------
0.40% First $250 million
0.38% Over $250 million, up to and including $500 million
0.36% In excess of $500 million
Annual Report | 27
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
3. TRANSACTIONS WITH AFFILIATES (CONTINUED)
B. ADMINISTRATIVE FEES
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.
C. SALES CHARGES/UNDERWRITING AGREEMENTS
Distributors has advised the Fund of the following commission transactions
related to the sales and redemptions of the Fund's shares for the year:
Sales charges retained net of commissions paid to unaffiliated
broker/dealers ............................................... $10,206
Contingent deferred sales charges retained ...................... $ 1,054
D. TRANSFER AGENT FEES
For the year ended September 30, 2008, the Fund paid transfer agent fees of
$216,561, of which $136,410 was retained by Investor Services.
E. OTHER AFFILIATED TRANSACTIONS
At September 30, 2008, Advisers or an affiliate owned 22.00% of the Fund's
outstanding shares.
4. EXPENSE OFFSET ARRANGEMENT
The Fund has entered into an arrangement with its custodian whereby credits
realized as a result of uninvested cash balances are used to reduce a portion of
the Fund's custodian expenses. During the year ended September 30, 2008, the
custodian fees were reduced as noted in the Statement of Operations.
5. INCOME TAXES
For tax purposes, capital losses may be carried over to offset future capital
gains, if any. At September 30, 2008, the capital loss carryforwards were as
follows:
Capital loss carryforwards expiring in:
2012 ................................. $ 6,223,578
2013 ................................. 4,584,050
2014 ................................. 2,817,022
2015 ................................. 4,099,588
2016 ................................. 2,076,095
-----------
$19,800,333
===========
28 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. INCOME TAXES (CONTINUED)
For tax purposes, realized capital losses occurring subsequent to October 31,
may be deferred and treated as occurring on the first day of the following
fiscal year. At September 30, 2008, the Fund deferred realized capital losses of
$1,590,444.
The tax character of distributions paid during the years ended September 30,
2008 and 2007, was as follows:
2008 2007
----------- -----------
Distributions paid from ordinary income .......... $11,828,294 $14,759,374
=========== ===========
At September 30, 2008, the cost of investments, net unrealized appreciation
(depreciation), and undistributed ordinary income for income tax purposes were
as follows:
Cost of investments ........................................... $255,811,438
============
Unrealized appreciation ....................................... $ 703,604
Unrealized depreciation ....................................... (19,716,602)
------------
Net unrealized appreciation (depreciation) .................... $(19,012,998)
============
Distributable earnings - undistributed ordinary income ........ $ 347,871
============
Net investment income differs for financial statement and tax purposes primarily
due to differing treatments of foreign currency transactions, mortgage dollar
rolls and paydown losses.
Net realized gains (losses) differ for financial statement and tax purposes
primarily due to differing treatments of wash sales, foreign currency
transactions, mortgage dollar rolls, financial futures transactions and paydown
losses.
6. INVESTMENT TRANSACTIONS
Purchases and sales of investments (excluding short term securities) for the
year ended September 30, 2008, aggregated $897,689,044 and $969,942,121,
respectively.
7. INVESTMENTS IN FRANKLIN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO
The Fund may invest in the Franklin Institutional Fiduciary Trust Money Market
Portfolio (Sweep Money Fund), an open-end investment company managed by
Advisers. Management fees paid by the Fund are reduced on assets invested in the
Sweep Money Fund, in an amount not to exceed the management and administrative
fees paid by the Sweep Money Fund.
Annual Report | 29
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
8. FINANCIAL FUTURES CONTRACTS
At September 30, 2008, the Fund had the following financial futures contracts
outstanding:
UNREALIZED
NUMBER OF DELIVERY CONTRACT APPRECIATION
CONTRACTS DATE FACE VALUE (DEPRECIATION)
--------- ---------- ---------- --------------
CONTRACTS TO SELL
U.S. Treasury Long Bond ...... 85 12/19/08 $8,500,000 $64,202
9. CONCENTRATION OF CREDIT RISK
The Fund has 33.3% of its net assets invested in asset-backed and commercial
mortgage-backed securities. Investments in these securities may subject the Fund
to increased market volatility which may cause the Fund's net asset value per
share to fluctuate. These investments may be less liquid than other investments
held by the Fund.
10. NEW ACCOUNTING PRONOUNCEMENTS
In September 2006, the Financial Accounting Standards Board (FASB) issued FASB
Statement No. 157, "Fair Value Measurement" (SFAS 157), which defines fair
value, establishes a framework for measuring fair value, and expands disclosures
about fair value measurements. SFAS 157 is effective for fiscal years beginning
after November 15, 2007, and interim periods within those fiscal years. The Fund
believes the adoption of SFAS 157 will not have a material impact on its
financial statements.
In March 2008, FASB issued FASB Statement No. 161, "Disclosures about Derivative
Instruments and Hedging Activities, an amendment of FASB Statement No. 133"
(SFAS 161), which expands disclosures about derivative investments and hedging
activities. SFAS 161 is effective for fiscal years and interim periods beginning
after November 15, 2008. The Fund is currently evaluating the impact, if any, of
applying the various provisions of SFAS 161.
30 | Annual Report
Franklin Strategic Mortgage Portfolio
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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, 2008, 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 five years in
the period then ended, 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 the standards of the
Public Company Accounting Oversight Board (United States). Those standards
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, 2008 by correspondence with the
custodian and brokers, provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Francisco, California
November 19, 2008
Annual Report | 31
Franklin Strategic Mortgage Portfolio
TAX DESIGNATION (UNAUDITED)
Under Section 871(k)(1)(C) of the Internal Revenue Code (Code), the Fund
designates the maximum amount allowable but no less than $10,372,279 as interest
related dividends for purposes of the tax imposed under Section 871(a)(1)(A) of
the Code for the fiscal year ended September 30, 2008.
32 | Annual Report
Franklin Strategic Mortgage Portfolio
BOARD MEMBERS AND OFFICERS
The name, year of birth and address of the officers and board members, as well
as their affiliations, positions held with the Trust, principal occupations
during the past five years and number of portfolios overseen in the Franklin
Templeton Investments fund complex are shown below. Generally, each board member
serves until that person's successor is elected and qualified.
INDEPENDENT BOARD MEMBERS
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------- ----------- -------------- ----------------------- ------------------------------------
HARRIS J. ASHTON (1932) Trustee Since 1992 144 Bar-S Foods (meat packing company).
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director of various companies; and FORMERLY, Director, RBC Holdings, Inc. (bank holding company) (until 2002); and
President, Chief Executive Officer and Chairman of the Board, General Host Corporation (nursery and craft centers)
(until 1998).
ROBERT F. CARLSON (1928) Trustee Since 2007 122 None
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Retired; and FORMERLY, Vice President, senior member and President, Board of Administration, California Public Employees
Retirement Systems (CALPERS) (1971-January 2008); member and Chairman of the Board, Sutter Community Hospitals; member,
Corporate Board, Blue Shield of California; and Chief Counsel, California Department of Transportation.
SAM GINN (1937) Trustee Since 2007 122 Chevron Corporation (global energy
One Franklin Parkway company) and ICO Global
San Mateo, CA 94403-1906 Communications (Holdings) Limited
(satellite company).
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Private investor; and FORMERLY, Chairman of the Board, Vodafone AirTouch, PLC (wireless company); Chairman of the Board
and Chief Executive Officer, AirTouch Communications (cellular communications) (1993-1998) and Pacific Telesis Groups
(telephone holding company) (1988-1994).
EDITH E. HOLIDAY (1952) Trustee Since 2003 144 Hess Corporation (exploration and
One Franklin Parkway refining of oil and gas), H.J. Heinz
San Mateo, CA 94403-1906 Company (processed foods and allied
products), RTI International Metals,
Inc. (manufacture and distribution
of titanium), Canadian National
Railway (railroad) and White
Mountains Insurance Group, Ltd.
(holding company).
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director or Trustee of various companies and trusts; and FORMERLY, Assistant to the President of the United States and
Secretary of the Cabinet (1990-1993); General Counsel to the United States Treasury Department (1989-1990); and
Counselor to the Secretary and Assistant Secretary for Public Affairs and Public Liaison-United States Treasury
Department (1988-1989).
Annual Report | 33
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------- ----------- -------------- ----------------------- -----------------------------------
FRANK W.T. LAHAYE (1929) Trustee Since 1992 122 Center for Creative Land Recycling
One Franklin Parkway (brownfield redevelopment).
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
General Partner, Las Olas L.P. (Asset Management); and FORMERLY, Chairman, Peregrine Venture Management Company (venture
capital).
FRANK A. OLSON (1932) Trustee Since 2007 144 Hess Corporation (exploration and
One Franklin Parkway refining of oil and gas) and
San Mateo, CA 94403-1906 Sentient Jet (private jet service).
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Chairman Emeritus, The Hertz Corporation (car rental) (since 2000) (Chairman of the Board (1980-2000) and Chief
Executive Officer (1977-1999)); and FORMERLY, Chairman of the Board, President and Chief Executive Officer, UAL
Corporation (airlines).
LARRY D. THOMPSON (1945) Trustee Since 2007 144 None
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Vice President - Government Affairs, General Counsel and Secretary, PepsiCo, Inc. (consumer products); and
FORMERLY, Director, Delta Airlines (aviation) (2003-2005) and Providian Financial Corp. (credit card provider)
(1997-2001); Senior Fellow of The Brookings Institution (2003-2004); Visiting Professor, University of Georgia School of
Law (2004); and Deputy Attorney General, U.S. Department of Justice (2001-2003).
JOHN B. WILSON (1959) Lead Trustee since 122 None
One Franklin Parkway Independent 2007 and Lead
San Mateo, CA 94403-1906 Trustee Independent
Trustee since
January 2008
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
President and Founder, Hyannis Port Capital, Inc. (real estate and private equity investing); serves on private and
non-profit boards; and FORMERLY, Chief Operating Officer and Executive Vice President, Gap, Inc. (retail) (1996-2000);
Chief Financial Officer and Executive Vice President - Finance and Strategy, Staples, Inc. (office supplies)
(1992-1996); Senior Vice President - Corporate Planning, Northwest Airlines, Inc. (airlines) (1990-1992); and Vice
President and Partner, Bain & Company (consulting firm) (1986-1990).
34 | Annual Report
INTERESTED BOARD MEMBERS AND OFFICERS
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------- --------------- ------------------ ----------------------- ------------------------
**CHARLES B. JOHNSON (1933) Trustee and Trustee since 144 None
One Franklin Parkway Chairman of 1992 and
San Mateo, CA 94403-1906 the Board Chairman of the
Board since 1993
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Chairman of the Board, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Director, Templeton Worldwide, Inc.;
and officer and/or director or trustee, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 42
of the investment companies in Franklin Templeton Investments.
**GREGORY E. JOHNSON (1961) Trustee Since 2007 95 None
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director, President and Chief Executive Officer, Franklin Resources, Inc.; President, Templeton Worldwide, Inc.; Director, Templeton
Asset Management Ltd.; and officer and/or director or trustee, as the case may be, of some of the other subsidiaries of Franklin
Resources, Inc. and of 33 of the investment companies in Franklin Templeton Investments.
JAMES M. DAVIS (1952) Chief Chief Compliance Not Applicable Not Applicable
One Franklin Parkway Compliance Officer since 2004
San Mateo, CA 94403-1906 Officer and and Vice President
Vice President - AML
- AML Compliance since
Compliance 2006
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director, Global Compliance, Franklin Resources, Inc.; officer of some of the other subsidiaries of Franklin Resources, Inc. and of
46 of the investment companies in Franklin Templeton Investments; and FORMERLY, Director of Compliance, Franklin Resources, Inc.
(1994-2001).
LAURA F. FERGERSON (1962) Treasurer, Treasurer since Not Applicable Not Applicable
One Franklin Parkway Chief Financial 2004, Chief
San Mateo, CA 94403-1906 Officer and Financial Officer
Chief and Chief
Accounting Accounting Officer
Officer since February
2008
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice President, Franklin Templeton Services, LLC; officer of 46 of the investment companies in Franklin Templeton Investments; and
FORMERLY, Director and member of Audit and Valuation Committees, Runkel Funds, Inc. (2003-2004); Assistant Treasurer of most of the
investment companies in Franklin Templeton Investments (1997-2003); and Vice President, Franklin Templeton Services, LLC
(1997-2003).
Annual Report | 35
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------- --------------- ------------------ ----------------------- ------------------------
JIMMY D. GAMBILL (1947) Vice President Since February Not Applicable Not Applicable
500 East Broward Blvd. 2008
Suite 2100
Fort Lauderdale, FL 33394-3091
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
President, Franklin Templeton Services, LLC; Senior Vice President, Templeton Worldwide, Inc.; and officer of some of the other
subsidiaries of Franklin Resources, Inc. and of 46 of the investment companies in Franklin Templeton Investments.
DAVID P. GOSS (1947) Vice President Since 2000 Not Applicable Not Applicable
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Associate General Counsel, Franklin Templeton Investments; officer and/or director of some of the other subsidiaries of
Franklin Resources, Inc.; and officer of 46 of the investment companies in Franklin Templeton Investments.
RUPERT H. JOHNSON, JR. (1940) President and President since Not Applicable Not Applicable
One Franklin Parkway Chief 1993 and Chief
San Mateo, CA 94403-1906 Executive Executive Officer
Officer - - Investment
Investment Management
Management since 2002
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Vice Chairman, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Director, Franklin Advisers, Inc. and
Templeton Worldwide, Inc.; Senior Vice President, Franklin Advisory Services, LLC; and officer and/or director or trustee, as the
case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 44 of the investment companies in Franklin
Templeton Investments.
KAREN L. SKIDMORE (1952) Vice President Since 2006 Not Applicable Not Applicable
One Franklin Parkway and Secretary
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Associate General Counsel, Franklin Templeton Investments; and officer of 30 of the investment companies in Franklin
Templeton Investments.
36 | Annual Report
NUMBER OF PORTFOLIOS IN
NAME, YEAR OF BIRTH LENGTH OF FUND COMPLEX OVERSEEN
AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD
- ------------------- --------------- ------------------ ----------------------- ------------------------
CRAIG S. TYLE (1960) Vice President Since 2005 Not Applicable Not Applicable
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
General Counsel and Executive Vice President, Franklin Resources, Inc.; officer of some of the other subsidiaries of Franklin
Resources, Inc. and of 46 of the investment companies in Franklin Templeton Investments; and FORMERLY, Partner, Shearman & Sterling,
LLP (2004-2005); and General Counsel, Investment Company Institute (ICI) (1997-2004).
GALEN G. VETTER (1951) Senior Vice Since February Not Applicable Not Applicable
500 East Broward Blvd. President and 2008
Suite 2100 Chief
Fort Lauderdale, FL 33394-3091 Executive
Officer -
Finance and
Administration
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Vice President, Franklin Templeton Services, LLC; officer of some of the other subsidiaries of Franklin Resources, Inc. and
of 46 of the investment companies in Franklin Templeton Investments; and FORMERLY, Managing Director, RSM McGladrey, Inc.
(1999-2004); and Partner, McGladrey & Pullen, LLP (1979-1987 and 1991-2004).
* We base the number of portfolios on each separate series of the U.S.
registered investment companies within the Franklin Templeton Investments
fund complex. These portfolios have a common investment manager or
affiliated investment managers.
** Charles B. Johnson is considered to be an interested person of the Fund
under the federal securities laws due to his position as officer and
director and major shareholder of Franklin Resources, Inc. (Resources),
which is the parent company of the Fund's investment manager and
distributor. Gregory E. Johnson is considered to be an interested person of
the Fund under the federal securities laws due to his position as an
officer and director of Resources.
Note 1: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers and the
father and uncle, respectively, of Gregory E. Johnson.
Note 2: Officer information is current as of the date of this report. It is
possible that after this date, information about officers may change.
THE SARBANES-OXLEY ACT OF 2002 AND RULES ADOPTED BY THE SECURITIES AND EXCHANGE
COMMISSION REQUIRE THE FUND TO DISCLOSE WHETHER THE FUND'S AUDIT COMMITTEE
INCLUDES AT LEAST ONE MEMBER WHO IS AN AUDIT COMMITTEE FINANCIAL EXPERT WITHIN
THE MEANING OF SUCH ACT AND RULES. THE FUND'S BOARD HAS DETERMINED THAT THERE IS
AT LEAST ONE SUCH FINANCIAL EXPERT ON THE AUDIT COMMITTEE AND HAS DESIGNATED
JOHN B. WILSON AS ITS AUDIT COMMITTEE FINANCIAL EXPERT. THE BOARD BELIEVES THAT
MR. WILSON QUALIFIES AS SUCH AN EXPERT IN VIEW OF HIS EXTENSIVE BUSINESS
BACKGROUND AND EXPERIENCE, INCLUDING SERVICE AS CHIEF FINANCIAL OFFICER OF
STAPLES, INC. FROM 1992 TO 1996. MR. WILSON HAS BEEN A MEMBER AND CHAIRMAN OF
THE FUND'S AUDIT COMMITTEE SINCE 2007. AS A RESULT OF SUCH BACKGROUND AND
EXPERIENCE, THE BOARD BELIEVES THAT MR. WILSON HAS ACQUIRED AN UNDERSTANDING OF
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND FINANCIAL STATEMENTS, THE GENERAL
APPLICATION OF SUCH PRINCIPLES IN CONNECTION WITH THE ACCOUNTING ESTIMATES,
ACCRUALS AND RESERVES, AND ANALYZING AND EVALUATING FINANCIAL STATEMENTS THAT
PRESENT A BREADTH AND LEVEL OF COMPLEXITY OF ACCOUNTING ISSUES GENERALLY
COMPARABLE TO THOSE OF THE FUND, AS WELL AS AN UNDERSTANDING OF INTERNAL
CONTROLS AND PROCEDURES FOR FINANCIAL REPORTING AND AN UNDERSTANDING OF AUDIT
COMMITTEE FUNCTIONS. MR. WILSON IS AN INDEPENDENT BOARD MEMBER AS THAT TERM IS
DEFINED UNDER THE RELEVANT SECURITIES AND EXCHANGE COMMISSION RULES AND
RELEASES.
THE STATEMENT OF ADDITIONAL INFORMATION (SAI) INCLUDES ADDITIONAL INFORMATION
ABOUT THE BOARD MEMBERS AND IS AVAILABLE, WITHOUT CHARGE, UPON REQUEST.
SHAREHOLDERS MAY CALL (800) DIAL BEN/(800) 342-5236 TO REQUEST THE SAI.
Annual Report | 37
Franklin Strategic Mortgage Portfolio
SHAREHOLDER INFORMATION
PROXY VOTING POLICIES AND PROCEDURES
The Trust's investment manager has established Proxy Voting Policies and
Procedures (Policies) that the Trust uses to determine how to vote proxies
relating to portfolio securities. Shareholders may view the Trust's complete
Policies online at franklintempleton.com. Alternatively, shareholders may
request copies of the Policies free of charge by calling the Proxy Group collect
at (954) 527-7678 or by sending a written request to: Franklin Templeton
Companies, LLC, 500 East Broward Boulevard, Suite 1500, Fort Lauderdale, FL
33394, Attention: Proxy Group. Copies of the Trust's proxy voting records are
also made available online at franklintempleton.com and posted on the U.S.
Securities and Exchange Commission's website at sec.gov and reflect the most
recent 12-month period ended June 30.
QUARTERLY STATEMENT OF INVESTMENTS
The Trust files a complete statement of investments with the U.S. Securities and
Exchange Commission for the first and third quarters for each fiscal year on
Form N-Q. Shareholders may view the filed Form N-Q by visiting the Commission's
website at sec.gov. The filed form may also be viewed and copied at the
Commission's Public Reference Room in Washington, DC. Information regarding the
operations of the Public Reference Room may be obtained by calling (800)
SEC-0330.
38 | Annual Report
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Literature Request
LITERATURE REQUEST. TO RECEIVE A BROCHURE AND PROSPECTUS, PLEASE CALL US AT
(800) DIAL BEN/(800) 342-5236 OR VISIT FRANKLINTEMPLETON.COM. INVESTORS SHOULD
CAREFULLY CONSIDER A FUND'S INVESTMENT GOALS, RISKS, CHARGES AND EXPENSES BEFORE
INVESTING. THE PROSPECTUS CONTAINS THIS AND OTHER INFORMATION. PLEASE CAREFULLY
READ THE PROSPECTUS BEFORE INVESTING. TO ENSURE THE HIGHEST QUALITY OF SERVICE,
WE MAY MONITOR, RECORD AND ACCESS TELEPHONE CALLS TO OR FROM OUR SERVICE
DEPARTMENTS. THESE CALLS CAN BE IDENTIFIED BY THE PRESENCE OF A REGULAR BEEPING
TONE.
FRANKLIN TEMPLETON FUNDS
VALUE
Franklin All Cap Value Fund
Franklin Balance Sheet Investment Fund
Franklin Large Cap Value Fund
Franklin MicroCap Value Fund(1)
Franklin MidCap Value Fund
Franklin Small Cap Value Fund
Mutual Beacon Fund
Mutual Qualified Fund
Mutual Recovery Fund(4)
Mutual Shares Fund
BLEND
Franklin Focused Core Equity Fund
Franklin Large Cap Equity Fund
Franklin Rising Dividends Fund
GROWTH
Franklin Capital Growth Fund
Franklin Flex Cap Growth Fund
Franklin Growth Fund
Franklin Growth Opportunities Fund(2)
Franklin Small Cap Growth Fund(3)
Franklin Small-Mid Cap Growth Fund
SECTOR
Franklin Biotechnology Discovery Fund
Franklin DynaTech Fund
Franklin Global Real Estate Fund
Franklin Gold and Precious Metals Fund
Franklin Natural Resources Fund
Franklin Real Estate Securities Fund
Franklin Utilities Fund
Mutual Financial Services Fund
GLOBAL
Mutual Discovery Fund
Templeton Global Long-Short Fund
Templeton Global Opportunities Trust
Templeton Global Smaller Companies Fund(1)
Templeton Growth Fund
Templeton World Fund
INTERNATIONAL
Franklin India Growth Fund
Franklin International Growth Fund
Franklin International Small Cap Growth Fund
Mutual European Fund
Templeton BRIC Fund
Templeton China World Fund
Templeton Developing Markets Trust
Templeton Emerging Markets Small Cap Fund
Templeton Foreign Fund
Templeton Foreign Smaller Companies Fund(1)
Templeton Frontier Markets Fund
HYBRID
Franklin Balanced Fund
Franklin Convertible Securities Fund
Franklin Equity Income Fund
Franklin Income Fund
Templeton Income Fund
ASSET ALLOCATION
Franklin Templeton Corefolio(R) Allocation Fund
Franklin Templeton Founding Funds Allocation Fund
Franklin Templeton Perspectives Allocation Fund
Franklin Templeton Conservative Target Fund
Franklin Templeton Growth Target Fund
Franklin Templeton Moderate Target Fund
Franklin Templeton 2015 Retirement Target Fund
Franklin Templeton 2025 Retirement Target Fund
Franklin Templeton 2035 Retirement Target Fund
Franklin Templeton 2045 Retirement Target Fund
FIXED INCOME
Franklin Adjustable U.S. Government Securities Fund(5)
Franklin Floating Rate Daily Access Fund
Franklin High Income Fund
Franklin Limited Maturity U.S. Government Securities Fund(5)
Franklin Low Duration Total Return Fund
Franklin Real Return Fund
Franklin Strategic Income Fund
Franklin Strategic Mortgage Portfolio
Franklin Templeton Hard Currency Fund
Franklin Total Return Fund
Franklin U.S. Government Securities Fund(5)
Templeton Global Bond Fund
Templeton Global Total Return Fund
Templeton International Bond Fund
TAX-FREE INCOME(6)
NATIONAL FUNDS
Double Tax-Free Income Fund
Federal Tax-Free Income Fund
High Yield Tax-Free Income Fund
Insured Tax-Free Income Fund(7)
LIMITED-/INTERMEDIATE-TERM FUNDS
California Intermediate-Term Tax-Free Income Fund
Federal Intermediate-Term Tax-Free Income Fund
Federal Limited-Term Tax-Free Income Fund
New York Intermediate-Term Tax-Free Income Fund
STATE-SPECIFIC
Alabama
Arizona
California(8)
Colorado
Connecticut
Florida
Georgia
Kentucky
Louisiana
Maryland
Massachusetts(7)
Michigan(7)
Minnesota(7)
Missouri
New Jersey
New York(8)
North Carolina
Ohio(7)
Oregon
Pennsylvania
Tennessee
Virginia
INSURANCE FUNDS
Franklin Templeton Variable Insurance Products Trust(9)
(1.) The fund is closed to new investors. Existing shareholders and select
retirement plans can continue adding to their accounts.
(2.) Effective 11/1/07, Franklin Aggressive Growth Fund changed its name to
Franklin Growth Opportunities Fund. The fund's investment goal and strategy
remained the same.
(3.) Effective 3/31/08, Franklin Small Cap Growth Fund II changed its name to
Franklin Small Cap Growth Fund. The fund's investment goal and strategy
remained the same.
(4.) The fund is a continuously offered, closed-end fund. Shares may be
purchased daily; there is no daily redemption. However, each quarter,
pending board approval, the fund will authorize the repurchase of 5%-25% of
the outstanding number of shares. Investors may tender all or a portion of
their shares during the tender period.
(5.) An investment in the fund is neither insured nor guaranteed by the U.S.
government or by any other entity or institution.
(6.) For investors subject to the alternative minimum tax, a small portion of
fund dividends may be taxable. Distributions of capital gains are generally
taxable.
(7.) The fund invests primarily in insured municipal securities.
(8.) These funds are available in four or more variations, including long-term
portfolios, intermediate-term portfolios, portfolios of insured securities,
a high-yield portfolio (CA only) and money market portfolios.
(9.) The funds of the Franklin Templeton Variable Insurance Products Trust are
generally available only through insurance company variable contracts.
11/08 Not part of the annual report
(FRANKLIN TEMPLETON INVESTMENTS(R) LOGO)
One Franklin Parkway
San Mateo, CA 94403-1906
WANT TO RECEIVE THIS DOCUMENT FASTER VIA EMAIL?
Eligible shareholders can sign up for eDelivery at franklintempleton.com.
See inside for details.
ANNUAL REPORT AND SHAREHOLDER LETTER
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
INVESTMENT MANAGER
Franklin Advisers, Inc.
DISTRIBUTOR
Franklin Templeton Distributors, Inc.
(800) DIAL BEN(R)
franklintempleton.com
SHAREHOLDER SERVICES
(800) 632-2301
Authorized for distribution only when accompanied or preceded by a prospectus.
Investors should carefully consider a fund's investment goals, risks, charges
and expenses before investing. The prospectus contains this and other
information; please read it carefully before investing.
To ensure the highest quality of service, telephone calls to or from our service
departments may be monitored, recorded and accessed. These calls can be
identified by the presence of a regular beeping tone.
157 A2008 11/08
ITEM 2. CODE OF ETHICS.
(a) The Registrant has adopted a code of ethics that applies to its principal
executive officers and principal financial and accounting officer.
(c) N/A
(d) N/A
(f) Pursuant to Item 12(a)(1), the Registrant is attaching as an exhibit a copy
of its code of ethics that applies to its principal executive officers and
principal financial and accounting officer.
ITEM 3. AUDIT COMMITTEE FINANCIAL EXPERT.
(a)(1) The Registrant has an audit committee financial expert serving on its
audit committee.
(2) The audit committee financial expert is John B. Wilson and he is
"independent" as defined under the relevant Securities and Exchange Commission
Rules and Releases.
ITEM 4. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
(a) Audit Fees
The aggregate fees paid to the principal accountant for professional services
rendered by the principal accountant for the audit of the registrant's annual
financial statements or for services that are normally provided by the principal
accountant in connection with statutory and regulatory filings or engagements
were $36,688 for the fiscal year ended September 30, 2008 and $28,825 for the
fiscal year ended September 30, 2007.
(b) Audit-Related Fees
There were no fees paid to the principal accountant for assurance and related
services rendered by the principal accountant to the registrant that are
reasonably related to the performance of the audit of the registrant's financial
statements and are not reported under paragraph (a) of Item 4.
There were no fees paid to the principal accountant for assurance and related
services rendered by the principal accountant to the registrant's investment
adviser and any entity controlling, controlled by or under common control with
the investment adviser that provides ongoing services to the registrant that are
reasonably related to the performance of the audit of their financial
statements.
(c) Tax Fees
There were no fees paid to the principal accountant for professional services
rendered by the principal accountant to the registrant for tax compliance, tax
advice and tax planning.
The aggregate fees paid to the principal accountant for professional services
rendered by the principal accountant to the registrant's investment adviser and
any entity controlling, controlled by or under common control with the
investment adviser that provides ongoing services to the registrant for tax
compliance, tax advice and tax planning were $0 for the fiscal year ended
September 30, 2008 and $46,000 for the fiscal year ended September 30, 2007. The
services for which these fees were paid included tax compliance and advice.
(d) All Other Fees
The aggregate fees paid to the principal accountant for products and services
rendered by the principal accountant to the registrant not reported in
paragraphs (a)-(c) of Item 4 were $152 for the fiscal year ended September 30,
2008 and $0 for the fiscal year ended September 30, 2007. The services for which
these fees were paid include review of materials provided to the fund Board in
connection with the investment management contract renewal process.
The aggregate fees paid to the principal accountant for products and services
rendered by the principal accountant to the registrant's investment adviser and
any entity controlling, controlled by or under common control with the
investment adviser that provides ongoing services to the registrant not reported
in paragraphs (a)-(c) of Item 4 were $283,925 for the fiscal year ended
September 30, 2008 and $0 for the fiscal year ended September 30, 2007. The
services for which these fees were paid include review of materials provided to
the fund Board in connection with the investment management contract renewal
process.
(e) (1) The registrant's audit committee is directly responsible for approving
the services to be provided by the auditors, including:
(i) pre-approval of all audit and audit related services;
(ii) pre-approval of all non-audit related services to be provided to
the Fund by the auditors;
(iii) pre-approval of all non-audit related services to be provided to
the registrant by the auditors to the registrant's investment adviser or to any
entity that controls, is controlled by or is under common control with the
registrant's investment adviser and that provides ongoing services to the
registrant where the non-audit services relate directly to the operations or
financial reporting of the registrant; and
(iv) establishment by the audit committee, if deemed necessary or
appropriate, as an alternative to committee pre-approval of services to be
provided by the auditors, as required by paragraphs (ii) and (iii) above, of
policies and procedures to permit such services to be pre-approved by other
means, such as through establishment of guidelines or by action of a designated
member or members of the committee; provided the policies and procedures are
detailed as to the particular service and the committee is informed of each
service and such policies and procedures do not include delegation of audit
committee responsibilities, as contemplated under the Securities Exchange Act of
1934, to management; subject, in the case of (ii) through (iv), to any waivers,
exceptions or exemptions that may be available under applicable law or rules.
(e) (2) None of the services provided to the registrant described in paragraphs
(b)-(d) of Item 4 were approved by the audit committee pursuant to paragraph
(c)(7)(i)(C) of Rule 2-01 of regulation S-X.
(f) No disclosures are required by this Item 4(f).
(g) The aggregate non-audit fees paid to the principal accountant for services
rendered by the principal accountant to the registrant and the registrant's
investment adviser and any entity controlling, controlled by or under common
control with the investment adviser that provides ongoing services to the
registrant were $284,077 for the fiscal year ended September 30, 2008 and
$46,000 for the fiscal year ended September 30, 2007.
(h) The registrant's audit committee of the board has considered whether the
provision of non-audit services that were rendered to the registrant's
investment adviser (not including any sub-adviser whose role is primarily
portfolio management and is subcontracted with or overseen by another investment
adviser), and any entity controlling, controlled by, or under common control
with the investment adviser that provides ongoing services to the registrant
that were not pre-approved pursuant to paragraph (c)(7)(ii) of Rule 2-01 of
Regulation S-X is compatible with maintaining the principal accountant's
independence.
ITEM 5. AUDIT COMMITTEE OF LISTED REGISTRANTS. N/A
ITEM 6. SCHEDULE OF INVESTMENTS. N/A
ITEM 7. DISCLOSURE OF PROXY VOTING POLICIES AND PROCEDURES FOR CLOSED-END
MANAGEMENT INVESTMENT COMPANIES. N/A
ITEM 8. PORTFOLIO MANAGERS OF CLOSED-END MANAGEMENT INVESTMENT COMPANIES.
N/A
ITEM 9. PURCHASES OF EQUITY SECURITIES BY CLOSED-END MANAGEMENT
INVESTMENT COMPANY AND AFFILIATED PURCHASERS. N/A
ITEM 10. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There have
been no changes to the procedures by which shareholders may recommend nominees
to the Registrant's Board of Trustees that would require disclosure herein.
ITEM 11. CONTROLS AND PROCEDURES. (A) EVALUATION OF DISCLOSURE CONTROLS
AND PROCEDURES. The Registrant maintains disclosure controls and procedures that
are designed to ensure that information required to be disclosed in the
Registrant's filings under the Securities Exchange Act of 1934 and the
Investment Company Act of 1940 is recorded, processed, summarized and reported
within the periods specified in the rules and forms of the Securities and
Exchange Commission. Such information is accumulated and communicated to the
Registrant's management, including its principal executive officer and principal
financial officer, as appropriate, to allow timely decisions regarding required
disclosure. The Registrant's management, including the principal executive
officer and the principal financial officer, recognizes that any set of controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives.
Within 90 days prior to the filing date of this Shareholder Report on Form
N-CSR, the Registrant had carried out an evaluation, under the supervision and
with the participation of the Registrant's management, including the
Registrant's principal executive officer and the Registrant's principal
financial officer, of the effectiveness of the design and operation of the
Registrant's disclosure controls and procedures. Based on such evaluation, the
Registrant's principal executive officer and principal financial officer
concluded that the Registrant's disclosure controls and procedures are
effective.
(b) CHANGES IN INTERNAL CONTROLS. There have been no significant changes in the
Registrant's internal controls or in other factors that could significantly
affect the internal controls subsequent to the date of their evaluation in
connection with the preparation of this Shareholder Report on Form N-CSR.
ITEM 12. EXHIBITS.
(a)(1) Code of Ethics
(a)(2) Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
of Galen G. Vetter, Chief Executive Officer - Finance and Administration, and
Laura F. Fergerson, Chief Financial Officer and Chief Accounting Officer
(b) Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of
Galen G. Vetter, Chief Executive Officer - Finance and Administration, and Laura
F. Fergerson, Chief Financial Officer and Chief Accounting Officer
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, the registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
FRANKLIN STRATEGIC MORTGAGE PORTFOLIO
By /s/GALEN G. VETTER
------------------
Galen G. Vetter
Chief Executive Officer - Finance and Administration
Date November 25, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
By /S/GALEN G. VETTER
------------------
Galen G. Vetter
Chief Executive Officer - Finance and Administration
Date November 25, 2008
By /S/LAURA F. FERGERSON
---------------------
Laura F. Fergerson
Chief Financial Officer and Chief Accounting Officer
Date November 25, 2008