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: 9/30/09
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Item 1. Reports to Stockholders.
SEPTEMBER 30, 2009
ANNUAL REPORT
AND SHAREHOLDER LETTER
(GRAPHIC)
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FIXED INCOME
FRANKLIN
STRATEGIC MORTGAGE PORTFOLIO
(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
SHAREHOLDER LETTER ........................................................ 1
ANNUAL REPORT
Franklin Strategic Mortgage Portfolio ..................................... 3
Performance Summary ....................................................... 8
Your Fund's Expenses ...................................................... 10
Financial Highlights and Statement of Investments ......................... 12
Financial Statements ...................................................... 18
Notes to Financial Statements ............................................. 21
Report of Independent Registered Public Accounting Firm ................... 31
Tax Designation ........................................................... 32
Board Members and Officers ................................................ 33
Shareholder Information ................................................... 38
Shareholder Letter
Dear Shareholder:
During the 12-month period ended September 30, 2009, economic activity weakened
before showing signs of stabilization. The slowdown began in 2008 with the U.S.
subprime mortgage and credit crises and eventually spread worldwide. Despite
coordinated efforts by many governments to address spreading liquidity and
credit problems, deteriorating economic conditions and mounting uncertainty
contributed to market woes through the period's first half. Later in the period,
some indicators offered a better economic outlook, and markets rallied beginning
in March 2009, erasing much of the earlier losses. At period-end, although some
observers thought the worst of the economic crises was behind us, others
believed significant challenges remained. We think it is important to put
short-term market developments in perspective. Keep in mind that as uncertain as
current conditions may be, we have navigated through past periods of high market
volatility by remaining committed to our long-term perspective and disciplined
investment philosophy. Although conditions remain challenging, our experience
gives us reason to be optimistic about future market stabilization and recovery.
Franklin Strategic Mortgage Portfolio's annual report goes into greater detail
about prevailing conditions during the period under review. In addition, the
portfolio managers discuss investment management decisions and Fund performance
for the period. You will also find performance data and financial information.
Please remember that all securities markets fluctuate, as do mutual share
prices.
If you would like more frequent updates, franklintempleton.com provides daily
prices, monthly performance figures, portfolio holdings and other information.
You can also access your account, buy and sell shares, read timely articles, and
find helpful financial planning tools. We hope you will take advantage of these
online services.
NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE
Not part of the annual report | 1
Although market conditions are constantly changing, we remain committed to our
disciplined strategy as we manage the Funds. As always, we recommend investors
consult their financial advisors and review their portfolios to design a
long-term strategy and portfolio allocation that meet their individual needs,
goals and risk tolerance. We firmly believe that most people benefit from
professional advice, and that advice is invaluable as investors navigate current
market conditions.
We thank you for investing with Franklin Templeton, welcome your questions and
comments, and look forward to serving your investment needs in the years ahead.
Sincerely,
/s/ Rupert H. Johnson, Jr.
Rupert H. Johnson, Jr.
President and Chief Executive Officer - Investment Management
Franklin Strategic Mortgage Portfolio
THIS LETTER REFLECTS OUR ANALYSIS AND OPINIONS AS OF SEPTEMBER 30, 2009. 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.
2 | Not part of the annual report
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 a portfolio of 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 9/30/09
(PIE CHART)
Federal National Mortgage Association (FNMA) ........................... 53.0%
Asset-Backed Securities & Commercial Mortgage-Backed Securities ........ 21.0%
Federal Home Loan Mortgage Corp. (FHLMC) ............................... 17.1%
Government National Mortgage Association (GNMA) ........................ 3.2%
Short-Term Investments ................................................. 5.7%
This annual report for Franklin Strategic Mortgage Portfolio covers the fiscal
year ended September 30, 2009.
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.
PERFORMANCE OVERVIEW
For the year under review, Franklin Strategic Mortgage Portfolio - Class A
delivered a +5.69% cumulative total return. The Fund underperformed its
(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 13.
Annual Report | 3
benchmark, the Citigroup U.S. Broad Investment-Grade (USBIG) Mortgage Index,
which had a +9.69% total return for the same period.(2) For comparison, the
Lipper U.S. Mortgage Funds Classification Average returned +7.52%, and the
Barclays Capital (BC) U.S. Treasury Index, a component of the BC U.S. Government
Index, returned +6.26%.(3) You can find the Fund's long-term performance data in
the Performance Summary beginning on page 8.
ECONOMIC AND MARKET OVERVIEW
During the 12-month period ended September 30, 2009, economic conditions
weakened before showing signs of recovery as many of the forces that had
hindered the economy dissipated. Early in the period, several financial
institutions failed or sought government assistance, credit markets seized up
and housing prices plummeted. In February 2009, The Conference Board's Consumer
Confidence Index fell to an all-time low since it began in 1967. The financial
system, however, avoided collapse, and later in the period, government stress
tests of banks were generally positive. Financial markets stabilized in response
to the federal stimulus package and the Federal Reserve Board's (Fed's)
interventions, and consumer confidence rebounded. In March, many investors
reentered the stock market and started a rally that brought the major indexes
off this cycle's lows. In the third quarter, a number of blue-chip companies
reported better-than-expected profits resulting from cost-cutting measures.
Manufacturing activity improved over the period. Economic activity as measured
by gross domestic product (GDP) fell for most of the period but rose near
period-end. In 2008's fourth quarter, GDP was an annualized -5.4%, followed by
annualized rates of -6.4%, -0.7% and 3.5% in each of the subsequent three
quarters. These positive
(2.) Source: (C) 2009 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.
(3.) Source: Lipper Inc. 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 9/30/09, the Lipper U.S. Mortgage
Funds Classification Average consisted of 95 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.
Source: (C) 2009 Morningstar. 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, and an index is not
representative of the Fund's portfolio.
4 | Annual Report
signs, however, were constrained by a rising unemployment rate, which reached
9.8% by period-end, a 26-year high.(4) Despite improving economic data, most
industries eliminated jobs.
Oil prices were volatile, falling from $100 per barrel at the beginning of the
period to a $31 low in December. As economic conditions improved, oil prices
rebounded to end the period at $71. Many other commodity prices followed similar
trends; therefore, as prices fell in late 2008, inflation remained muted, and
September 2009's inflation rate was an annualized -1.3%.(4) Core inflation,
which excludes food and energy costs, rose at a 1.5% annualized rate, which was
within the Fed's informal target range of 1.5% to 2.0%.(4) The core personal
consumption expenditures price index reported a 12-month increase of 1.3%.(5)
A slowing economy and decelerating inflation prompted policymakers to lower
interest rates and enact stimulus plans. During the period, the Fed lowered the
federal funds target rate from 2.00% to a range of 0% to 0.25%. The government
implemented the American Recovery and Reinvestment Act, which included tax
breaks, money for ailing state governments, aid to the poor and unemployed, and
spending on infrastructure, renewable energy, health care and education. The Fed
and U.S. Treasury Department also launched programs designed to shore up
beleaguered banks' capital, enable freer lending to businesses and consumers,
help struggling home buyers avoid foreclosure, and boost auto sales. Near
period-end, the Fed assessed which support programs it created or expanded could
be phased out.
Most Treasury prices rose during the period, and fixed income spreads were
generally wide relative to Treasury yields due to heightened market turbulence
and risk aversion. Spreads for high yield bonds hit record levels. The spread
between two-year and 10-year Treasury yields rose to 236 basis points (100 basis
points equal one percentage point) at the end of September from 185 basis points
at the beginning of the reporting period. The two-year Treasury bill yield fell
from 2.00% to 0.95% over the 12-month period, while the 10-year Treasury note
yield fell from 3.85% to 3.31%.
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 Investors
(4.) Source: Bureau of Labor Statistics.
(5.) Source: Bureau of Economic Analysis.
Annual Report | 5
DIVIDEND DISTRIBUTIONS*
10/1/08-9/30/09
MONTH DIVIDEND PER SHARE
----- ------------------
October 4.3177 cents
November 3.9033 cents
December 4.4512 cents
January 4.0718 cents
February 4.3462 cents
March 4.6790 cents
April 4.5011 cents
May 3.9937 cents
June 4.5892 cents
July 4.4465 cents
August 4.3537 cents
September 4.2101 cents
-------------
TOTAL 51.8635 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.
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 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
During the first half of the 12-month reporting period, economic conditions
continued to deteriorate, but the second half ended on a more favorable and
optimistic tone as certain economic data indicated the recession was ending. In
the ongoing effort to stabilize financial markets and restore confidence to
investors, the U.S. Treasury and the Fed announced several new initiatives aimed
at increasing credit availability and reducing mortgage rates. Many observers,
however, faced with the prospects of a lengthy housing market rebound, ongoing
deleveraging and rising unemployment, harbored concerns about the strength of
the economy.
As measured by BC indexes, most sectors posted positive returns and outperformed
U.S. Treasuries, including asset-backed securities (ABS) (+14.68%), U.S.
residential mortgage-backed securities (MBS) (+9.85%) and commercial
mortgage-backed securities (CMBS) (+7.56%).(6) The BC U.S. Treasury Index lagged
with a +6.26% total return.(3)
The Fund used a broad mortgage strategy that looked across all mortgage
opportunity sets to find relative value, and our investment process and strategy
did not change. The management team continued to look for strong cash flow
fundamentals and valuations to uncover opportunities across the mortgage
investment universe.
We continued to invest in fixed income securities from higher quality
securitized sectors as we found fundamentally sound bonds at what we considered
attractive yields in these markets. The MBS market posted strong returns and
benefited Fund performance. We remained allocated to higher quality ABS and
CMBS. Both sectors had positive returns during the period, but the widening risk
premiums and increased volatility these sectors experienced in the first half of
the period negatively affected the Fund's performance. In our analysis, given
ongoing foreclosure and default conditions, we expected the commercial
(6.) Source: (C) 2009 Morningstar. 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. MBS Index is the MBS
component of the BC U.S. Aggregate Index and covers agency mortgage-backed
pass-through securities (both fixed rate and hybrid adjustable-rate
mortgage securities) issued by GNMA, FNMA, and FHLMC. 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.
6 | Annual Report
real estate sector to remain challenging. The Fund's CMBS allocations, however,
were top-rated securities that were high in the capital structure and benefited
from high levels of credit protection.
During the period, the Fed's $1.25 trillion agency mortgage purchase program
provided support to the agency MBS market. The Fed introduced the program, first
announced in November 2008, to facilitate mortgage credit availability during
the financial downturn, and it is expected to conclude by March 31, 2010. As the
end of the program approaches, the market has begun to focus on the Fed's
strategy to exit the program, which created a less favorable technical
environment. Prepayment risk for higher coupon MBS continued to be restrained as
declining home price appreciation, loss of home equity and tighter underwriting
standards limited mortgage borrowers' ability to refinance their homes. In this
environment, we increased the portfolio's allocation to some higher coupon MBS.
Our heaviest allocation was in coupons in the 5.0% through 6.0% range.
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, 2009, 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.
Annual Report | 7
Performance Summary as of 9/30/09
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 9/30/09 9/30/08
----------------------- ------ ------- -------
Net Asset Value (NAV) -$0.05 $8.75 $8.80
DISTRIBUTIONS (10/1/08-9/30/09)
Dividend Income $0.518635
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) +5.69% +15.58% +62.96%
Average Annual Total Return(3) +1.21% +2.05% +4.55%
Distribution Rate(4) 5.60%
30-Day Standardized Yield(5) 3.85%
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.
8 | Annual Report
Performance Summary (CONTINUED)
TOTAL RETURN INDEX COMPARISON FOR A 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.
CLASS A (10/1/99-9/30/09)
CITIGROUP U.S. BROAD
FRANKLIN STRATEGIC MORTGAGE INVESTMENT-GRADE
DATE PORTFOLIO - CLASS A MORTGAGE INDEX
------------- --------------------------- --------------------
10/1/1999 $ 9,577 $10,000
10/31/1999 $ 9,619 $10,053
11/30/1999 $ 9,628 $10,061
12/31/1999 $ 9,603 $10,028
1/31/2000 $ 9,528 $ 9,952
2/29/2000 $ 9,635 $10,069
3/31/2000 $ 9,733 $10,177
4/30/2000 $ 9,747 $10,181
5/31/2000 $ 9,756 $10,190
6/30/2000 $ 9,959 $10,410
7/31/2000 $10,027 $10,476
8/31/2000 $10,182 $10,631
9/30/2000 $10,305 $10,744
10/31/2000 $10,382 $10,824
11/30/2000 $10,540 $10,984
12/31/2000 $10,749 $11,160
1/31/2001 $10,902 $11,334
2/28/2001 $10,966 $11,396
3/31/2001 $11,039 $11,470
4/30/2001 $11,051 $11,482
5/31/2001 $11,114 $11,553
6/30/2001 $11,161 $11,570
7/31/2001 $11,348 $11,785
8/31/2001 $11,445 $11,892
9/30/2001 $11,604 $12,068
10/31/2001 $11,754 $12,231
11/30/2001 $11,681 $12,119
12/31/2001 $11,648 $12,075
1/31/2002 $11,756 $12,194
2/28/2002 $11,871 $12,327
3/31/2002 $11,748 $12,203
4/30/2002 $11,979 $12,430
5/31/2002 $12,064 $12,521
6/30/2002 $12,168 $12,623
7/31/2002 $12,312 $12,765
8/31/2002 $12,403 $12,877
9/30/2002 $12,508 $12,971
10/31/2002 $12,550 $13,020
11/30/2002 $12,546 $13,008
12/31/2002 $12,679 $13,145
1/31/2003 $12,710 $13,182
2/28/2003 $12,787 $13,272
3/31/2003 $12,801 $13,268
4/30/2003 $12,855 $13,319
5/31/2003 $12,885 $13,325
6/30/2003 $12,896 $13,354
7/31/2003 $12,650 $13,113
8/31/2003 $12,731 $13,198
9/30/2003 $12,933 $13,424
10/31/2003 $12,874 $13,378
11/30/2003 $12,916 $13,417
12/31/2003 $13,045 $13,548
1/31/2004 $13,129 $13,634
2/29/2004 $13,253 $13,753
3/31/2004 $13,290 $13,813
4/30/2004 $13,097 $13,571
5/31/2004 $13,071 $13,527
6/30/2004 $13,166 $13,644
7/31/2004 $13,265 $13,772
8/31/2004 $13,487 $13,999
9/30/2004 $13,503 $14,018
10/31/2004 $13,600 $14,138
11/30/2004 $13,565 $14,096
12/31/2004 $13,635 $14,200
1/31/2005 $13,705 $14,272
2/28/2005 $13,664 $14,210
3/31/2005 $13,624 $14,172
4/30/2005 $13,762 $14,339
5/31/2005 $13,879 $14,455
6/30/2005 $13,911 $14,505
7/31/2005 $13,839 $14,437
8/31/2005 $13,972 $14,566
9/30/2005 $13,873 $14,485
10/31/2005 $13,787 $14,392
11/30/2005 $13,831 $14,436
12/31/2005 $13,945 $14,587
1/31/2006 $13,977 $14,622
2/28/2006 $14,036 $14,699
3/31/2006 $13,922 $14,566
4/30/2006 $13,904 $14,569
5/31/2006 $13,880 $14,530
6/30/2006 $13,897 $14,570
7/31/2006 $14,091 $14,786
8/31/2006 $14,271 $15,001
9/30/2006 $14,390 $15,100
10/31/2006 $14,484 $15,214
11/30/2006 $14,636 $15,385
12/31/2006 $14,587 $15,340
1/31/2007 $14,592 $15,353
2/28/2007 $14,759 $15,541
3/31/2007 $14,805 $15,581
4/30/2007 $14,874 $15,654
5/31/2007 $14,778 $15,554
6/30/2007 $14,686 $15,473
7/31/2007 $14,709 $15,575
8/31/2007 $14,744 $15,790
9/30/2007 $14,922 $15,916
10/31/2007 $15,012 $16,073
11/30/2007 $15,145 $16,370
12/31/2007 $15,212 $16,412
1/31/2008 $15,232 $16,718
2/29/2008 $15,026 $16,722
3/31/2008 $15,047 $16,819
4/30/2008 $15,134 $16,821
5/31/2008 $15,140 $16,723
6/30/2008 $15,052 $16,718
7/31/2008 $14,813 $16,688
8/31/2008 $14,752 $16,884
9/30/2008 $14,766 $17,079
10/31/2008 $14,268 $16,799
11/30/2008 $13,912 $17,507
12/31/2008 $14,242 $17,806
1/31/2009 $14,396 $17,835
2/28/2009 $14,300 $17,932
3/31/2009 $14,483 $18,208
4/30/2009 $14,717 $18,243
5/31/2009 $15,013 $18,270
6/30/2009 $14,918 $18,287
7/31/2009 $15,225 $18,442
8/31/2009 $15,355 $18,572
9/30/2009 $15,607 $18,733
Total Returns 56.07% 87.33%
AVERAGE ANNUAL TOTAL RETURN
CLASS A 9/30/09
------- -------
1-Year +1.21%
5-Year +2.05%
10-Year +4.55%
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 $9.14 on 9/30/09.
(5.) The 30-day standardized yield for the 30 days ended 9/30/09 reflects an
estimated yield to maturity (assuming all portfolio securities are held to
maturity). It should be regarded as an estimate of the Fund's rate of
investment income, and it may not equal the Fund's actual income
distribution rate (which reflects the Fund's past dividends paid to
shareholders) or the income reported in the Fund's financial statements.
(6.) Figures are as stated in the Fund's prospectus current as of the date of
this report. In periods of market volatility, assets may decline
significantly, causing total annual Fund operating expenses to become
higher than the figures shown.
(7.) Source: (C) 2009 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.
Annual Report | 9
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
- 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.
10 | Annual Report
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.
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 4/1/09 VALUE 9/30/09 PERIOD* 4/1/09-9/30/09
------- ----------------- -------------- ----------------------
Actual $1,000 $1,077.60 $3.75
Hypothetical (5% return before expenses) $1,000 $1,021.46 $3.65
* Expenses are calculated using the most recent six-month annualized expense
ratio of 0.72%, multiplied by the average account value over the period,
multiplied by 183/365 to reflect the one-half year period.
Annual Report | 11
Franklin Strategic Mortgage Portfolio
FINANCIAL HIGHLIGHTS
YEAR ENDED SEPTEMBER 30,
----------------------------------------------------------
2009 2008 2007 2006 2005
-------- -------- -------- -------- --------
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net asset value, beginning of year .......................... $ 8.80 $ 9.42 $ 9.59 $ 9.73 $ 9.96
-------- -------- -------- -------- --------
Income from investment operations(a):
Net investment income .................................... 0.306 0.404 0.476 0.418 0.391
Net realized and unrealized gains (losses) ............... 0.163 (0.493) (0.129) (0.069) (0.123)
-------- -------- -------- -------- --------
Total from investment operations ............................ 0.469 (0.089) 0.347 0.349 0.268
-------- -------- -------- -------- --------
Less distributions from net investment income ............... (0.519) (0.531) (0.517) (0.489) (0.498)
-------- -------- -------- -------- --------
Redemption fees(b) .......................................... -- --(c) --(c) --(c) --(c)
-------- -------- -------- -------- --------
Net asset value, end of year ................................ $ 8.75 $ 8.80 $ 9.42 $ 9.59 $ 9.73
======== ======== ======== ======== ========
Total return(d) ............................................. 5.69% (1.04)% 3.70% 3.73% 2.74%
RATIOS TO AVERAGE NET ASSETS
Expenses(e) ................................................. 0.67% 0.57% 0.57% 0.55% 0.55%
Net investment income ....................................... 4.16% 4.58% 5.05% 4.48% 3.97%
SUPPLEMENTAL DATA
Net assets, end of year (000's) ............................. $101,961 $168,674 $243,664 $287,865 $367,759
Portfolio turnover rate ..................................... 273.38% 336.36% 326.67% 247.03% 160.36%
Portfolio turnover rate excluding mortgage dollar rolls(f) .. 9.39% 25.39% 30.85% 38.75% 36.26%
(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) Effective September 1, 2008, the redemption fee was eliminated.
(c) Amount rounds to less than $0.001 per share.
(d) Total return does not reflect sales commissions or contingent deferred
sales charges, if applicable.
(e) Benefit of expense reduction rounds to less than 0.01%.
(f) See Note 1(f) regarding mortgage dollar rolls.
The accompanying notes are an integral part of these financial statements.
12 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2009
PRINCIPAL
AMOUNT(a) VALUE
------------- -------------
MORTGAGE-BACKED SECURITIES 93.5%
(b) FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) ADJUSTABLE RATE 7.5%
FHLMC, 2.875%, 4/01/17 .................................................................. 41,677 $ 41,822
FHLMC, 3.102%, 5/01/22 .................................................................. 60,643 61,248
FHLMC, 3.118%, 11/01/25 ................................................................. 72,834 74,509
FHLMC, 3.169%, 5/01/20 .................................................................. 175,754 177,073
FHLMC, 3.359%, 3/01/19 .................................................................. 188,224 192,535
FHLMC, 3.375%, 4/01/18 .................................................................. 66,131 67,226
FHLMC, 3.386%, 7/01/22 .................................................................. 974,059 988,616
FHLMC, 3.533%, 8/01/31 .................................................................. 30,908 31,790
FHLMC, 3.586%, 11/01/16 ................................................................. 326,528 330,788
FHLMC, 4.034%, 1/01/31 .................................................................. 162,353 166,599
FHLMC, 4.06%, 4/01/31 ................................................................... 67,031 68,007
FHLMC, 4.101%, 12/01/30 ................................................................. 108,800 110,423
FHLMC, 4.389%, 1/01/32 .................................................................. 61,204 61,603
FHLMC, 5.253%, 4/01/30 .................................................................. 1,229,870 1,263,275
FHLMC, 5.274%, 7/01/24 .................................................................. 135,157 137,023
FHLMC, 5.287%, 1/01/28 .................................................................. 271,166 274,088
FHLMC, 5.504%, 4/01/24 .................................................................. 195,057 197,307
FHLMC, 5.89%, 7/01/30 ................................................................... 530,034 542,161
FHLMC, 5.963%, 10/01/36 ................................................................. 2,371,058 2,495,780
FHLMC, 5.978%, 10/01/18 ................................................................. 161,391 165,152
FHLMC, 6.868%, 11/01/19 ................................................................. 142,543 150,454
-------------
7,597,479
-------------
FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) FIXED RATE 14.3%
FHLMC Gold 15 Year, 6.50%, 4/01/11 ...................................................... 227 238
FHLMC Gold 15 Year, 7.00%, 7/01/11 ...................................................... 696 726
FHLMC Gold 15 Year, 7.50%, 4/01/10 ...................................................... 323 332
FHLMC Gold 15 Year, 8.00%, 12/01/12 ..................................................... 9,147 9,245
(c) FHLMC Gold 30 Year, 5.00%, 10/01/33 - 10/01/39 .......................................... 1,932,226 2,002,209
FHLMC Gold 30 Year, 5.50%, 9/01/33 ...................................................... 383,188 403,326
FHLMC Gold 30 Year, 6.00%, 7/01/28 - 12/01/32 ........................................... 43,598 46,500
(c) FHLMC Gold 30 Year, 6.00%, 10/01/39 ..................................................... 6,000,000 6,332,814
FHLMC Gold 30 Year, 6.50%, 2/01/19 - 7/01/32 ............................................ 1,078,610 1,163,845
(c) FHLMC Gold 30 Year, 6.50%, 10/01/39 ..................................................... 1,250,000 1,332,227
FHLMC Gold 30 Year, 7.50%, 10/01/25 - 8/01/32 ........................................... 718,631 807,570
FHLMC Gold 30 Year, 8.00%, 7/01/24 - 5/01/30 ............................................ 163,091 184,588
FHLMC Gold 30 Year, 8.50%, 10/01/17 - 9/01/30 ........................................... 330,244 359,673
FHLMC Gold 30 Year, 9.00%, 9/01/30 ...................................................... 108,809 125,163
FHLMC Gold 30 Year, 9.50%, 12/01/16 - 4/01/25 ........................................... 830,147 934,507
FHLMC PC 30 Year, 8.50%, 2/01/17 - 5/01/17 .............................................. 720,631 780,987
FHLMC PC 30 Year, 9.00%, 6/01/16 ........................................................ 1,357 1,497
FHLMC PC 30 Year, 9.25%, 8/01/14 ........................................................ 3,752 4,098
FHLMC PC 30 Year, 9.50%, 8/01/19 ........................................................ 101,599 112,114
-------------
14,601,659
-------------
Annual Report | 13
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2009 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
------------- -------------
MORTGAGE-BACKED SECURITIES (CONTINUED)
(b) FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) ADJUSTABLE RATE 9.0%
FNMA, 2.528%, 4/01/31 ................................................................... 64,827 $ 66,282
FNMA, 2.849%, 1/01/18 ................................................................... 1,889,309 1,907,662
FNMA, 2.95%, 4/01/21 .................................................................... 13,578 13,652
FNMA, 3.00%, 11/01/28 ................................................................... 130,723 133,577
FNMA, 3.02%, 7/01/27 .................................................................... 136,791 139,277
FNMA, 3.166%, 4/01/18 ................................................................... 29,150 29,459
FNMA, 3.181%, 11/01/31 .................................................................. 354,778 363,477
FNMA, 3.198%, 1/01/17 ................................................................... 568,487 576,110
FNMA, 3.215%, 5/01/31 ................................................................... 27,736 28,472
FNMA, 3.27%, 8/01/29 .................................................................... 46,157 46,837
FNMA, 3.271%, 2/01/32 ................................................................... 147,919 151,653
FNMA, 3.275%, 6/01/31 ................................................................... 366,570 367,863
FNMA, 3.335%, 10/01/32 .................................................................. 189,351 191,545
FNMA, 3.396%, 4/01/27 ................................................................... 178,596 179,753
FNMA, 3.449%, 9/01/32 ................................................................... 427,267 429,245
FNMA, 3.52%, 7/01/26 .................................................................... 42,472 42,601
FNMA, 3.662%, 7/01/19 ................................................................... 1,042,036 1,060,734
FNMA, 3.733%, 4/01/33 ................................................................... 219,874 226,279
FNMA, 3.768%, 12/01/22 .................................................................. 139,766 141,846
FNMA, 4.029%, 8/01/27 ................................................................... 157,153 160,569
FNMA, 4.039%, 7/01/14 ................................................................... 231,465 234,353
FNMA, 4.113%, 7/01/25 ................................................................... 61,194 63,070
FNMA, 4.402%, 7/01/17 - 12/01/31 ........................................................ 198,451 205,506
FNMA, 4.425%, 5/01/30 ................................................................... 186,547 191,002
FNMA, 4.496%, 10/01/24 .................................................................. 323,375 327,423
FNMA, 4.589%, 10/01/19 .................................................................. 222,567 231,286
FNMA, 4.603%, 4/01/18 ................................................................... 170,826 175,608
FNMA, 4.875%, 9/01/18 ................................................................... 47,130 47,416
FNMA, 4.945%, 5/01/27 ................................................................... 110,849 111,954
FNMA, 5.012%, 5/01/21 ................................................................... 274,430 281,577
FNMA, 5.191%, 12/01/24 .................................................................. 86,373 88,505
FNMA, 5.382%, 6/01/17 ................................................................... 86,305 88,832
FNMA, 5.389%, 8/01/26 ................................................................... 128,496 132,003
FNMA, 5.424%, 7/01/31 ................................................................... 710,719 734,686
-------------
9,170,114
-------------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE 58.7%
FNMA 15 Year, 5.00%, 6/01/18 ............................................................ 747,124 793,878
FNMA 15 Year, 5.00%, 7/01/18 ............................................................ 2,684,996 2,854,696
FNMA 15 Year, 5.50%, 5/01/14 - 2/01/18 .................................................. 2,440,318 2,613,114
FNMA 15 Year, 6.50%, 4/01/11 - 10/01/16 ................................................. 216,973 234,164
FNMA 15 Year, 7.00%, 11/01/11 ........................................................... 327 340
FNMA 15 Year, 7.50%, 6/01/11 - 7/01/12 .................................................. 15,373 15,972
FNMA 15 Year, 9.00%, 2/01/11 - 11/01/11 ................................................. 68,090 70,411
(c) FNMA 30 Year, 4.50%, 10/01/39 ........................................................... 5,000,000 5,065,625
FNMA 30 Year, 5.00%, 4/01/34 ............................................................ 1,047,171 1,086,320
(c) FNMA 30 Year, 5.00%, 10/01/39 ........................................................... 13,000,000 13,428,597
FNMA 30 Year, 5.50%, 11/01/33 ........................................................... 1,046,901 1,101,591
14 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2009 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
------------- -------------
MORTGAGE-BACKED SECURITIES (CONTINUED)
FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) FIXED RATE (CONTINUED)
FNMA 30 Year, 5.50%, 11/01/34 ........................................................... 7,786,024 $ 8,183,030
FNMA 30 Year, 5.50%, 9/01/33 - 11/01/35 ................................................. 6,226,090 6,549,073
FNMA 30 Year, 6.00%, 9/01/32 ............................................................ 1,006,711 1,074,884
FNMA 30 Year, 6.00%, 10/01/34 ........................................................... 1,451,693 1,542,742
FNMA 30 Year, 6.00%, 10/01/34 ........................................................... 4,020,621 4,272,789
FNMA 30 Year, 6.00%, 11/01/34 ........................................................... 1,385,218 1,472,097
FNMA 30 Year, 6.00%, 7/01/35 ............................................................ 1,173,767 1,255,003
FNMA 30 Year, 6.00%, 12/01/23 - 8/01/35 ................................................. 772,547 822,374
FNMA 30 Year, 6.50%, 12/01/27 - 8/01/32 ................................................. 5,216,893 5,634,060
FNMA 30 Year, 7.50%, 8/01/25 - 5/01/32 .................................................. 271,352 303,617
FNMA 30 Year, 8.00%, 1/01/25 - 7/01/31 .................................................. 65,991 74,826
FNMA 30 Year, 8.50%, 11/01/26 - 11/01/28 ................................................ 759,281 868,605
FNMA 30 Year, 9.00%, 12/01/16 - 9/01/26 ................................................. 56,121 61,701
FNMA 30 Year, 9.50%, 11/01/15 - 4/01/30 ................................................. 183,862 203,815
FNMA 30 Year, 10.00%, 8/01/15 - 4/01/21 ................................................. 222,041 248,528
FNMA 30 Year, 10.50%, 1/01/16 - 5/01/30 ................................................. 14,246 16,184
FNMA 30 Year, 11.00%, 10/01/15 .......................................................... 5,402 5,669
FNMA 30 Year, 12.00%, 4/01/15 - 5/01/16 ................................................. 2,517 2,819
FNMA 30 Year, 12.50%, 12/01/13 .......................................................... 415 471
-------------
59,856,995
-------------
(b) GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) ADJUSTABLE RATE 0.2%
GNMA, 4.125%, 11/20/25 .................................................................. 66,288 67,453
GNMA, 4.625%, 7/20/27 ................................................................... 180,486 184,906
-------------
252,359
-------------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA) FIXED RATE 3.8%
GNMA I SF 15 Year, 7.00%, 4/15/14 ....................................................... 12,982 13,962
GNMA I SF 15 Year, 8.00%, 9/15/15 ....................................................... 24,933 26,987
GNMA I SF 30 Year, 6.50%, 1/15/24 - 9/15/32 ............................................. 586,404 632,069
GNMA I SF 30 Year, 7.00%, 3/15/17 - 2/15/32 ............................................. 540,407 589,848
GNMA I SF 30 Year, 7.50%, 10/15/23 - 10/15/29 ........................................... 79,449 88,905
GNMA I SF 30 Year, 8.00%, 1/15/17 - 9/15/27 ............................................. 259,638 290,418
GNMA I SF 30 Year, 8.25%, 1/15/21 - 5/15/21 ............................................. 169,037 191,800
GNMA I SF 30 Year, 8.50%, 6/15/16 - 7/15/24 ............................................. 375,661 421,360
GNMA I SF 30 Year, 9.00%, 9/15/16 - 8/15/28 ............................................. 61,253 68,045
GNMA I SF 30 Year, 9.50%, 11/15/09 - 1/15/10 ............................................ 3,439 3,482
GNMA I SF 30 Year, 10.00%, 12/15/18 - 2/15/19 ........................................... 6,976 7,839
GNMA I SF 30 Year, 10.50%, 1/15/16 ...................................................... 900 1,006
GNMA II SF 30 Year, 6.50%, 1/20/26 - 1/20/33 ............................................ 737,199 794,675
GNMA II SF 30 Year, 7.50%, 11/20/22 - 7/20/32 ........................................... 460,431 513,630
GNMA II SF 30 Year, 8.00%, 1/20/17 - 8/20/26 ............................................ 145,487 160,252
GNMA II SF 30 Year, 8.50%, 7/20/16 - 8/20/16 ............................................ 67,099 72,644
GNMA II SF 30 Year, 9.00%, 11/20/19 - 3/20/25 ........................................... 6,366 7,279
GNMA II SF 30 Year, 10.50%, 6/20/20 ..................................................... 25 28
-------------
3,884,229
-------------
TOTAL MORTGAGE-BACKED SECURITIES (COST $93,018,423) ..................................... 95,362,835
-------------
Annual Report | 15
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2009 (CONTINUED)
PRINCIPAL
AMOUNT(a) VALUE
------------- -------------
ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES 26.9%
FINANCE 26.9%
(b) AFC Home Equity Loan Trust, 1997-4, 2A2, 0.886%, 12/22/27 ............................... 384,913 $ 226,649
(b) Ameriquest Mortgage Securities Inc., 2003-12, M2, 1.946%, 1/25/34 ....................... 968,265 340,523
(b, d) Bayview Commercial Asset Trust, 2006-CD1A, A-1, 144A, 0.685%, 7/25/23 (Canada) .......... 1,250,395 CAD 1,090,346
(b, d) Bear Stearns Commercial Mortgage Securities Inc., 2007-T26, B, 144A, 5.769%, 1/12/45 .... 2,650,000 715,855
CitiFinancial Mortgage Securities Inc., 2003-4, AF6, 4.493%, 10/25/33 ................... 1,843,286 1,613,340
Citigroup/Deutsche Bank Commercial Mortgage Trust, 2007-CD4, C, 5.476%, 12/11/49 ........ 6,500,000 1,364,867
(b) Contimortgage Home Equity Loan Trust, 1999-3, A6, 8.18%, 12/25/29 ....................... 10,943 10,889
Countrywide Asset-Backed Certificates,
2004-7, AF4, 4.774%, 8/25/32 ......................................................... 136,060 135,652
(b) 2006-11, 1AF1, 0.366%, 9/25/46 ....................................................... 217,613 210,760
(b) FHLMC, 2942, TF, 0.593%, 3/15/35 ........................................................ 919,996 915,396
(b) First Fran klin Mortgage Loan Asset-Backed Certificates,
2004-FF11, 1A2, 0.596%, 1/25/35 ...................................................... 280,716 217,377
2006-FF12, A2, 0.286%, 9/25/36 ....................................................... 243,760 239,286
FNMA,
(b) 2007-1, NF, 0.496%, 2/25/37 .......................................................... 870,424 843,088
G93-33, K, 7.00%, 9/25/23 ............................................................ 1,566,966 1,741,415
GE Capital Commercial Mortgage Corp., 2003-C1, A4, 4.819%, 1/10/38 ...................... 1,262,683 1,294,862
Greenwich Capital Commercial Funding Corp.,
2004-GG1, A7, 5.317%, 6/10/36 ........................................................ 5,000,000 5,066,205
2007-GG9, C, 5.554%, 3/10/39 ......................................................... 3,500,000 1,075,889
JPMorgan Chase Commercial Mortgage Securities Corp.,
(b) 2004-CB9, A4, 5.377%, 6/12/41 ........................................................ 3,779,632 3,726,489
2004-LN2, A2, 5.115%, 7/15/41 ........................................................ 557,685 535,268
(b) Merrill Lynch Mortgage Investors Trust, 2006-RM2, A1B, 0.481%, 5/25/37 .................. 3,580,013 172,083
(b) Morgan Stanley Capital I Trust, 2004-IQ7, A4, 5.402%, 6/15/38 ........................... 2,500,000 2,483,196
(b) Novastar Home Equity Loan , 2004-4, M4, 1.346%, 3/25/35 ................................. 1,500,000 792,987
(b) Ownit Mortgage Loan Asset-Backed Certificates, 2006-6, A2B, 0.356%, 9/25/37 ............. 1,772,069 1,284,111
Residential Asset Securities Corp.,
2004-KS1, AI4, 4.213%, 4/25/32 ....................................................... 612,627 556,773
(b) 2005-AHL2, A2, 0.506%, 10/25/35 ...................................................... 123,960 106,555
(b) Structured Asset Investment Loan Trust, 2004-1, M5, 4.746%, 2/25/34 ..................... 434,772 49,812
(b, d) Structured Asset Securities Corp., 2005-SC1, 1A1, 144A, 0.516%, 5/25/31 ................. 719,019 376,729
(b) Travelers Mortgage Services Inc., 1998-5A, A, 4.604%, 12/25/18 .......................... 102,000 89,760
Vanderbilt Mortgage Finance, 1998-C, 1A6, 6.75%, 10/07/28 ............................... 100,000 90,073
-------------
TOTAL ASSET-BACKED SECURITIES AND COMMERCIAL MORTGAGE-BACKED SECURITIES
(COST $43,836,734) ................................................................... 27,366,235
-------------
TOTAL INVESTMENTS BEFORE SHORT TERM INVESTMENTS (COST $136,855,157) ..................... 122,729,070
-------------
SHORT TERM INVESTMENTS 7.3%
U.S. GOVERNMENT AND AGENCY SECURITIES (COST $99,976) 0.1%
(e, f) U.S. Treasury Bill, 11/27/09 ............................................................ 100,000 99,993
-------------
TOTAL INVESTMENTS BEFORE MONEY MARKET FUNDS AND REPURCHASE AGREEMENTS
(COST $136,955,133) .................................................................. 122,829,063
-------------
16 | Annual Report
Franklin Strategic Mortgage Portfolio
STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2009 (CONTINUED)
SHARES VALUE
------------- -------------
SHORT TERM INVESTMENTS (CONTINUED)
MONEY MARKET FUNDS (COST $5,145,455) 5.0%
(g) Institutional Fiduciary Trust Money Market Portfolio, 0.00% ............................ 5,145,455 $ 5,145,455
-------------
PRINCIPAL
AMOUNT
-------------
REPURCHASE AGREEMENTS (COST $2,203,608) 2.2%
(h) Joint Repurchase Agreement, 0.029%, 10/01/09 (Maturity Value $2,203,610) ................ $ 2,203,608 2,203,608
Banc of America Securities LLC (Maturity Value $277,875)
Barclays Capital Inc. (Maturity Value $326,487)
BNP Paribas Securities Corp. (Maturity Value $555,729)
Credit Suisse Securities (USA) LLC (Maturity Value $347,333)
Deutsche Bank Securities Inc. (Maturity Value $209,938)
HSBC Securities (USA) Inc. (Maturity Value $208,395)
Morgan Stanley & Co. Inc. (Maturity Value $208,395)
UBS Securities LLC (Maturity Value $69,458)
Collateralized by U.S. Government Agency Securities, 0.50% - 5.00%, 3/19/10 -
2/13/17;
(e) U.S. Government Agency Discount Notes, 12/31/09 - 4/26/10;
(e) U.S. Treasury Bills, 6/10/20; and U.S. Treasury Notes, 1.50% - 4.125%, 7/15/10 -
8/31/14
-------------
TOTAL INVESTMENTS (COST $144,304,196) 127.7% ................................................... 130,178,126
OTHER ASSETS, LESS LIABILITIES (27.7)% ......................................................... (28,217,268)
-------------
NET ASSETS 100.0% .............................................................................. $ 101,960,858
=============
See Abbreviations on page 30.
(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 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,
2009, the aggregate value of these securities was $2,182,930, representing
2.14% of net assets.
(e) The security is traded on a discount basis with no stated coupon rate.
(f) Security or a portion of the security has been segregated as collateral for
open future contracts. At September 30, 2009, the value of this security
amounted to $99,993.
(g) See Note 7 regarding investments in the Institutional Fiduciary Trust Money
Market Portfolio. The rate shown is the annualized seven-day yield at
period end.
(h) See Note 1(c) regarding joint repurchase agreement.
At September 30, 2009, the Fund had the following financial futures contracts
outstanding. See Note 1(e).
NUMBER OF NOTIONAL DELIVERY UNREALIZED UNREALIZED
DESCRIPTION TYPE CONTRACTS AMOUNT DATE APPRECIATION DEPRECIATION
----------- ----- --------- ---------- -------- ------------ ------------
U.S. Treasury Long Bond ........................ Short 13 $1,577,875 12/21/09 $-- $(29,688)
--- --------
Net unrealized appreciation (depreciation) .. $(29,688)
========
The accompanying notes are an integral part of these financial statements.
Annual Report | 17
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS
STATEMENT OF ASSETS AND LIABILITIES
September 30, 2009
Assets:
Investments in securities:
Cost - Unaffiliated issuers ...................................... $136,955,133
Cost - Sweep Money Fund (Note 7) .................................. 5,145,455
Cost - Repurchase agreements ...................................... 2,203,608
------------
Total cost of investments ......................................... $144,304,196
============
Value - Unaffiliated issuers ...................................... $122,829,063
Value - Sweep Money Fund (Note 7) ................................. 5,145,455
Value - Repurchase agreements ..................................... 2,203,608
------------
Total value of investments ........................................ 130,178,126
Receivables:
Investment securities sold ........................................ 116,788
Capital shares sold ............................................... 49,340
Interest .......................................................... 467,208
Variation margin .................................................. 3,250
Other assets ......................................................... 114
------------
Total assets ................................................... 130,814,826
------------
Liabilities:
Payables:
Investment securities purchased ................................... 26,675,600
Capital shares redeemed ........................................... 1,892,606
Affiliates ........................................................ 152,787
Distributions to shareholders ..................................... 79,514
Accrued expenses and other liabilities ............................... 53,461
------------
Total liabilities .............................................. 28,853,968
------------
Net assets, at value ........................................ $101,960,858
============
Net assets consist of:
Paid-in capital ...................................................... $145,713,605
Undistributed net investment income .................................. 15,713
Net unrealized appreciation (depreciation) ........................... (14,155,758)
Accumulated net realized gain (loss) ................................. (29,612,702)
------------
Net assets, at value ........................................ $101,960,858
============
Shares outstanding ...................................................... 11,649,489
============
Net asset value per share(a) ............................................ $ 8.75
============
Maximum offering price per share (net asset value per share / 95.75%) ... $ 9.14
============
(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.
18 | Annual Report
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS (CONTINUED)
STATEMENT OF OPERATIONS
for the year ended September 30, 2009
Investment income:
Dividends from Sweep Money Fund (Note 7) ............................. $ 19,173
Interest ............................................................. 5,960,803
-----------
Total investment income ........................................ 5,979,976
-----------
Expenses:
Management fees (Note 3a) ............................................ 484,503
Transfer agent fees (Note 3d) ........................................ 197,139
Custodian fees (Note 4) .............................................. 2,606
Reports to shareholders .............................................. 44,306
Registration and filing fees ......................................... 37,035
Professional fees .................................................... 34,694
Trustees' fees and expenses .......................................... 7,914
Other ................................................................ 21,834
-----------
Total expenses ................................................. 830,031
Expense reductions (Note 4) .................................... (97)
-----------
Net expenses ................................................ 829,934
-----------
Net investment income .................................... 5,150,042
-----------
Realized and unrealized gains (losses):
Net realized gain (loss) from:
Investments ....................................................... (6,088,232)
Foreign currency transactions ..................................... (496)
Futures contracts ................................................. 483,021
-----------
Net realized gain (loss) ................................. (5,605,707)
-----------
Net change in unrealized appreciation (depreciation) on investments .. 4,502,109
-----------
Net realized and unrealized gain (loss) ................................. (1,103,598)
-----------
Net increase (decrease) in net assets resulting from operations ......... $ 4,046,444
===========
The accompanying notes are an integral part of these financial statements.
Annual Report | 19
Franklin Strategic Mortgage Portfolio
FINANCIAL STATEMENTS (CONTINUED)
STATEMENTS OF CHANGES IN NET ASSETS
YEAR ENDED SEPTEMBER 30,
---------------------------
2009 2008
------------ ------------
Increase (decrease) in net assets:
Operations:
Net investment income ............................................. $ 5,150,042 $ 9,425,095
Net realized gain (loss) from investments, foreign currency
transactions and futures contracts ............................. (5,605,707) 809,204
Net change in unrealized appreciation (depreciation) on investments
and translation of other assets and liabilities denominated in
foreign currencies ............................................. 4,502,109 (11,622,461)
------------ ------------
Net increase (decrease) in net assets resulting from
operations ............................................... 4,046,444 (1,388,162)
Distributions to shareholders from net investment income ............. (7,591,198) (11,828,294)
Capital share transactions (Note 2) .................................. (63,168,758) (61,774,422)
Redemption fees ...................................................... -- 1,432
------------ ------------
Net increase (decrease) in net assets .......................... (66,713,512) (74,989,446)
Net assets:
Beginning of year .................................................... 168,674,370 243,663,816
------------ ------------
End of year .......................................................... $101,960,858 $168,674,370
============ ============
Undistributed net investment income (distributions in excess of net
investment income) included in net assets:
End of year .......................................................... $ 15,713 $ (94,425)
============ ============
The accompanying notes are an integral part of these financial statements.
20 | 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 an 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
Government securities, mortgage-backed securities, asset-backed securities,
collateralized debt obligations and other debt 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. Debt securities denominated in a foreign currency
are converted into their U.S. dollar equivalent at the foreign exchange rate in
effect at the close of the NYSE on the date that the values of the foreign debt
securities are determined. Investments in open-end mutual funds are valued at
the closing net asset value.
The Fund 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 based upon the underlying investment book value,
anticipated future cash flows, market changes in comparable or similar
securities, 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 Fund'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 date of valuation. Purchases and sales of
securities, income and expense items denominated in
Annual Report | 21
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
B. FOREIGN CURRENCY TRANSLATION (CONTINUED)
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 Fund'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, 2009. 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.
22 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
E. DERIVATIVE FINANCIAL INSTRUMENTS
The Fund may invest in derivative financial instruments (derivatives) in order
to manage risk or gain exposure to various other investments or markets.
Derivatives are financial contracts based on an underlying or notional amount,
require no initial investment or an initial net investment that is smaller than
would normally be required to have a similar response to changes in market
factors, and require or permit net settlement. Derivatives may contain various
risks including the potential inability of the counterparty to fulfill their
obligations under the terms of the contract, the potential for an illiquid
secondary market, and the potential for market movements which may expose the
Fund to gains or losses in excess of the amounts shown on the Statement of
Assets and Liabilities.
Derivatives are marked to market daily based upon quotations from market makers
or the Fund's independent pricing services and the Fund's net benefit or
obligation under the contract, as measured by the fair market value of the
contract, is included in net assets. Realized gain and loss and unrealized
appreciation and depreciation on these contracts for the period are included in
the Statement of Operations.
The Fund enters into financial futures contracts in order to manage interest
rate risk. A futures contract is an agreement between the Fund and a
counterparty to buy or sell a security for a specific price on a future date.
Required initial margin deposits of cash or securities are pledged or received
by the Fund. Subsequent payments, known as variation margin, are made or
received by the Fund, depending on fluctuations in the value of the underlying
security. Such variation margin is accounted for as unrealized appreciation or
depreciation until the contract is closed, at which time the gains or losses are
realized.
See Note 10 regarding other derivative information.
F. 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 invest 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 | 23
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
G. 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, 2009, and has
determined that no provision for income tax is required in the Fund's financial
statements.
H. 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; these dividends are reinvested
and paid monthly to shareholders. Distributions to shareholders 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.
I. 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.
J. 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.
K. 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
24 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
K. GUARANTEES AND INDEMNIFICATIONS (CONTINUED)
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, 2009, there were an unlimited number of shares authorized
(without par value). Transactions in the Fund's shares were as follows:
YEAR ENDED SEPTEMBER 30,
------------------------------------------------------
2009 2008
-------------------------- -------------------------
SHARES AMOUNT SHARES AMOUNT
----------- ------------ ---------- ------------
Shares sold ....................... 2,023,648 $ 17,174,222 1,571,128 $ 14,491,454
Shares issued in reinvestment of
distributions .................. 719,481 6,078,949 1,079,811 9,945,846
Shares redeemed ................... (10,256,488) (86,421,929) (9,359,274) (86,211,722)
----------- ------------ ---------- ------------
Net increase (decrease) ........... (7,513,359) $(63,168,758) (6,708,335) $(61,774,422)
=========== ============ ========== ============
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 | 25
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 .. $21,967
Contingent deferred sales charges retained ..................................... $ 354
D. TRANSFER AGENT FEES
For the year ended September 30, 2009, the Fund paid transfer agent fees of
$197,139, of which $113,060 was retained by Investor Services.
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, 2009, 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, 2009, 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
2017 ............................... 2,449,042
-----------
$22,249,375
===========
For tax purposes, realized capital losses and realized currency 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, 2009, the Fund deferred
realized capital losses and realized currency losses of $7,378,443 and $14,001,
respectively.
26 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. INCOME TAXES (CONTINUED)
The tax character of distributions paid during the years ended September 30,
2009 and 2008, was as follows:
2009 2008
---------- -----------
Distributions paid from ordinary income .. $7,591,198 $11,828,294
========== ===========
At September 30, 2009, the cost of investments, net unrealized appreciation
(depreciation), and undistributed ordinary income for income tax purposes were
as follows:
Cost of investments ...................................... $144,475,990
============
Unrealized appreciation .................................. $ 2,498,968
Unrealized depreciation .................................. (16,796,832)
------------
Net unrealized appreciation (depreciation) ............... $(14,297,864)
============
Distributable earnings - undistributed ordinary income ... $ 266,450
============
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, 2009, aggregated $426,926,487 and $529,213,636,
respectively.
7. INVESTMENTS IN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO
The Fund may invest in the 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.
8. CONCENTRATION OF CREDIT RISK
The Fund has 21.0% of its portfolio 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.
Annual Report | 27
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. CREDIT FACILITY
Effective January 23, 2009, the Fund, together with other U.S. registered and
foreign investment funds managed by Franklin Templeton Investments
(individually, "Borrower"; collectively "Borrowers"), entered into a joint
syndicated senior unsecured credit facility totaling $725 million (Global Credit
Facility) to provide a source of funds to the Borrowers for temporary and
emergency purposes, including the ability to meet future unanticipated or
unusually large redemption requests.
Under the terms of the Global Credit Facility, the Fund shall, in addition to
interest charged on any borrowings made by the Fund and other costs incurred by
the Fund, pay its share of fees and expenses incurred in connection with the
implementation and maintenance of the Global Credit Facility, based upon its
relative share of the aggregate net assets of all of the Borrowers, including an
annual commitment fee based upon the unused portion of the Global Credit
Facility. During the period, the Fund incurred commitment fees of $255 of its
pro rata portion of the Global Credit Facility, which is reflected in other
expenses on the Statement of Operations. During the year ended September 30,
2009, the Fund did not utilize the Global Credit Facility.
10. OTHER DERIVATIVE INFORMATION
At September 30, 2009, the Fund has invested in derivative contracts which are
reflected on the Statement of Assets and Liabilities as follows:
ASSET DERIVATIVES LIABILITY DERIVATIVES
DERIVATIVE CONTRACTS ---------------------------------------- ------------------------------------
NOT ACCOUNTED FOR AS STATEMENT OF ASSETS AND FAIR VALUE STATEMENT OF ASSETS AND FAIR VALUE
HEDGING INSTRUMENTS LIABILITIES LOCATION AMOUNT LIABILITIES LOCATION AMOUNT
--------------------------- --------------------------- ---------- ----------------------- ----------
Financial Futures Contracts Variation margin/Unrealized Unrealized appreciation
appreciation (depreciation) $--(a) (depreciation) $(29,688)(a)
The effect of derivative contracts on the Fund's Statement of Operations was as
follows:
AVERAGE
NOTIONAL
AMOUNT
DERIVATIVE CONTRACTS UNREALIZED OUTSTANDING
NOT ACCOUNTED FOR AS STATEMENT OF REALIZED APPRECIATION DURING
HEDGING INSTRUMENTS OPERATIONS LOCATIONS GAIN (LOSS)(b) (DEPRECIATION)(b) THE PERIOD(b)
--------------------------- ------------------------------ -------------- ----------------- -------------
Financial Futures Contracts Net realized gain (loss) from
futures contracts / Net change
in unrealized appreciation
(depreciation) on investments $181,877 $194,154 $3,432,887
(a) Includes cumulative appreciation (depreciation) of futures contracts as
reported in Statement of Investments. Only current day's variation margin
is reported within the Statement of Assets and Liablilities.
(b) For the six months ended September 30, 2009.
See Note 1(e) regarding derivative financial instruments.
28 | Annual Report
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
11. FAIR VALUE MEASUREMENTS
The Fund follows a fair value hierarchy that distinguishes between market data
obtained from independent sources (observable inputs) and the Fund's own market
assumptions (unobservable inputs). These inputs are used in determining the
value of the Fund's investments and are summarized in the following fair value
hierarchy:
- Level 1 - quoted prices in active markets for identical securities
- Level 2 - other significant observable inputs (including quoted prices
for similar securities, interest rates, prepayment speed, credit risk,
etc.)
- Level 3 - significant unobservable inputs (including the Fund's own
assumptions in determining the fair value of investments)
The inputs or methodology used for valuing securities are not an indication of
the risk associated with investing in those securities.
The following is a summary of the inputs used as of September 30, 2009, in
valuing the Fund's assets and liabilities carried at fair value:
LEVEL 1 LEVEL 2 LEVEL 3 TOTAL
---------- ------------ ------- ------------
ASSETS:
Investments in Securities:
Mortgage-Backed Securities $ -- $ 95,362,835 $-- $ 95,362,835
Asset-Backed Securities and
Commercial Mortgage-Backed
Securities -- 27,366,235 -- 27,366,235
Short Term Investments 5,245,448 2,203,608 -- 7,449,056
---------- ------------ --- ------------
Total Investments in Securities $5,245,448 $124,932,678 $-- $130,178,126
========== ============ === ============
LIABILITIES:
Financial Futures Contracts 29,688 -- -- 29,688
At September 30, 2009, the reconciliation of assets in which significant
unobservable inputs (Level 3) were used in determining fair value, is as
follows:
NET CHANGE
BALANCE AT IN UNREALIZED TRANSFER IN
BEGINNING NET REALIZED APPRECIATION NET PURCHASES (OUT) OF BALANCE AT
OF YEAR GAIN (LOSS) (DEPRECIATION) (SALES) LEVEL 3 END OF YEAR
---------- ------------ -------------- ------------- ----------- -----------
ASSETS:
Asset-Backed Securities and
Commercial Mortgage-Backed
Securities ....................... $882,421 $(1,799) $(178,730) $(319,754) $(382,138) $--
Annual Report | 29
Franklin Strategic Mortgage Portfolio
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
12. SUBSEQUENT EVENTS
The Fund has evaluated subsequent events through November 16, 2009, the issuance
date of the financial statements and determined that no events have occurred
that require disclosure.
ABBREVIATIONS
CURRENCY
CAD - Canadian Dollar
SELECTED PORTFOLIO
PC - Participation Certificate
SF - Single Family
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, 2009, 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, 2009 by correspondence with the
custodian and brokers, provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
San Francisco, California
November 16, 2009
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 $6,537,386 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, 2009.
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 134 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 111 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) (1971-2008); 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 111 ICO Global Communications
One Franklin Parkway (Holdings) Limited (satellite
San Mateo, CA 94403-1906 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 134 Hess Corporation (exploration and
One Franklin Parkway refining of oil and gas), H.J.
San Mateo, CA 94403-1906 Heinz 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 111 None
One Franklin Parkway
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 134 Hess Corporation (exploration and
One Franklin Parkway refining of oil and gas).
San Mateo, CA 94403-1906
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 142 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 111 None
One Franklin Parkway Independent 2007 and Lead
San Mateo, CA 94403-1906 Trustee Independent
Trustee since
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).
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 134 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 41
of the investment companies in Franklin Templeton Investments.
34 | 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
------------------------------ --------------- ----------------- ----------------------- -----------------------------------
**GREGORY E. JOHNSON (1961) Trustee Since 2007 90 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.; and officer and/or
director or trustee, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 32 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
San Mateo, CA 94403-1906 Officer and 2004 and Vice
Vice President 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
45 of the investment companies in Franklin Templeton Investments; and FORMERLY, Director of Compliance, Franklin Resources, Inc.
(1994-2001).
LAURA F. FERGERSON (1962) Chief Since March 2009 Not Applicable Not Applicable
One Franklin Parkway Executive
San Mateo, CA 94403-1906 Officer -
Finance and
Administration
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Vice President, Franklin Templeton Services, LLC; officer of 45 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).
GASTON GARDEY (1967) Treasurer, Since March 2009 Not Applicable Not Applicable
One Franklin Parkway Chief Financial
San Mateo, CA 94403-1906 Officer and
Chief
Accounting
Officer
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Director, Fund Accounting, Franklin Templeton Investments; and officer of 27 of the investment companies in Franklin Templeton
Investments.
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
------------------------------ --------------- ----------------- ----------------------- -----------------------------------
ALIYA S. GORDON (1973) Vice President Since March 2009 Not Applicable Not Applicable
One Franklin Parkway
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Associate General Counsel, Franklin Templeton Investments; officer of 45 of the investment companies in Franklin Templeton
Investments; and FORMERLY, Litigation Associate, Steefel, Levitt & Weiss, LLP (2000-2004).
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, as the case may be, of some of the other
subsidiaries of Franklin Resources, Inc. and of 45 of the investment companies in Franklin Templeton Investments.
STEVEN J. GRAY (1955) Vice President Since August Not Applicable Not Applicable
One Franklin Parkway 2009
San Mateo, CA 94403-1906
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Associate General Counsel, Franklin Templeton Investments; Vice President, Franklin Templeton Distributors, Inc.; and officer
of 45 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 43 of the investment companies in Franklin
Templeton Investments.
ROBERT C. ROSSELOT (1960) Vice President Since August Not Applicable Not Applicable
500 East Broward Blvd. 2009
Suite 2100
Fort Lauderdale, FL 33394-3091
PRINCIPAL OCCUPATION DURING PAST 5 YEARS:
Senior Associate General Counsel, Franklin Templeton Investments; Assistant Secretary, Franklin Resources, Inc.; Vice President and
Secretary, Templeton Investment Counsel, LLC; Vice President, Secretary and Trust Officer, Fiduciary Trust International of the
South; and officer of 45 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
------------------------------ --------------- ----------------- ----------------------- -----------------------------------
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 45 of the investment companies in Franklin
Templeton Investments.
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 45 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).
* 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 A 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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Franklin Templeton Funds
LITERATURE REQUEST. TO RECEIVE A 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.
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 Quest Fund
Mutual Recovery Fund(2)
Mutual Shares Fund
BLEND
Franklin Focused Core Equity Fund
Franklin Large Cap Equity Fund
Franklin Rising Dividends Fund
GROWTH
Franklin Flex Cap Growth Fund
Franklin Growth Fund
Franklin Growth Opportunities Fund
Franklin Small Cap Growth Fund
Franklin Small-Mid Cap Growth Fund
SECTOR
Franklin Biotechnology Discovery Fund
Franklin DynaTech Fund
Franklin Global Real Estate Fund
Franklin Gold & Precious Metals Fund
Franklin Natural Resources Fund
Franklin Real Estate Securities Fund
Franklin Utilities Fund
Mutual Financial Services Fund
GLOBAL
Mutual Global Discovery Fund
Templeton Global Long-Short Fund
Templeton Global Opportunities Trust
Templeton Global Smaller Companies Fund
Templeton Growth Fund
Templeton World Fund
INTERNATIONAL
Franklin India Growth Fund
Franklin International Growth Fund
Franklin International Small Cap Growth Fund
Mutual European Fund
Mutual International 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
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(3)
Franklin Floating Rate Daily Access Fund
Franklin High Income Fund
Franklin Limited Maturity U.S. Government Securities Fund(3)
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(3)
Templeton Global Bond Fund
Templeton Global Total Return Fund
Templeton International Bond Fund
TAX-FREE INCOME(4)
NATIONAL
Double Tax-Free Income Fund
Federal Tax-Free Income Fund
High Yield Tax-Free Income Fund
Insured Tax-Free Income Fund(5)
LIMITED-/INTERMEDIATE-TERM
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(6)
Colorado
Connecticut
Florida
Georgia
Kentucky
Louisiana
Maryland
Massachusetts(7)
Michigan(7)
Minnesota(7)
Missouri
New Jersey
New York(6)
North Carolina
Ohio(7)
Oregon
Pennsylvania
Tennessee
Virginia
INSURANCE FUNDS
Franklin Templeton Variable Insurance Products Trust(8)
(1.) The fund is closed to new investors. Existing shareholders and select
retirement plans can continue adding to their accounts.
(2.) 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.
(3.) An investment in the fund is neither insured nor guaranteed by the U.S.
government or by any other entity or institution.
(4.) For investors subject to the alternative minimum tax, a small portion of
fund dividends may be taxable. Distributions of capital gains are generally
taxable.
(5.) The fund invests primarily in insured municipal securities.
(6.) 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.
(7.) The Board of Trustees approved the elimination of the non-fundamental
policy requiring the fund to invest at least 80% of net assets in insured
municipal securities and the removal of the word "Insured" from the fund
name. The changes became effective 2/17/09.
(8.) The funds of the Franklin Templeton Variable Insurance Products Trust are
generally available only through insurance company variable contracts.
04/09 Not part of the annual report
(FRANKLIN TEMPLETON INVESTMENTS(R) LOGO)
One Franklin Parkway
San Mateo, CA 94403-1906
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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 A2009 11/09
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 $27,163 for the fiscal year ended September 30, 2009 and $38,402 for the
fiscal year ended September 30, 2008.
(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 $2,762 for the fiscal year ended
September 30, 2009 and $4,000 for the fiscal year ended September 30, 2008. 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 $0 for the fiscal year ended September 30,
2009 and $152 for the fiscal year ended September 30, 2008. 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 $0 for the fiscal year ended September 30,
2009 and $283,925 for the fiscal year ended September 30, 2008. 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 $2,762 for the fiscal year ended September 30, 2009 and $288,077
for the fiscal year ended September 30, 2008.
(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 Laura F. Fergerson, Chief Executive Officer - Finance and Administration, and
Gaston Gardey, Chief Financial Officer and Chief Accounting Officer
(b) Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of
Laura F. Fergerson, Chief Executive Officer - Finance and Administration, and
Gaston Gardey, 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/LAURA F. FERGERSON
---------------------------
Laura F. Fergerson
Chief Executive Officer - Finance and Administration
Date November 25, 2009
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/LAURA F. FERGERSON
---------------------------
Laura F. Fergerson
Chief Executive Officer - Finance and Administration
Date November 25, 2009
By /s/GASTON GARDEY
----------------------------
Gaston Gardey
Chief Financial Officer and
Chief Accounting Officer
Date November 25, 2009