N-CSR 1 fsmpncsrform.txt 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 811-7288 -------- Franklin Strategic Mortgage Portfolio ------------------------------------- (Exact name of registrant as specified in charter) One Franklin Parkway, San Mateo, CA 94403-1906 (Address of principal executive offices) (Zip code) Murray L. Simpson, 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 -------------- Date of fiscal year end: 9/30 ---- Date of reporting period: 9/30/03 ------- Item 1. Reports to Stockholders. SEPTEMBER 30, 2003 [GRAPHIC OMITTED] ANNUAL REPORT AND SHAREHOLDER LETTER INCOME Franklin Strategic Mortgage Portfolio Want to receive this document FASTER via email? Eligible shareholders can sign up for eDelivery at franklintempleton.com. See inside for details. [GRAPHIC OMITTED] [LOGO OMITTED] FRANKLIN(R) TEMPLETON(R) INVESTMENTS Franklin o Templeton o Mutual Series FRANKLIN TEMPLETON INVESTMENTS GAIN FROM OUR PERSPECTIVE 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 leader in tax-free investing and a driving force in fixed income investing around the globe. They also bring 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 research offices in over 25 countries, they offer investors the broadest global reach in the industry. MUTUAL SERIES. Established in 1949, Mutual Series is dedicated to a unique style of value investing, searching aggressively for opportunity among undervalued stocks, arbitrage situations and distressed companies. TRUE DIVERSIFICATION Because our management groups work independently and adhere to distinctly different investment approaches, Franklin, Templeton and Mutual Series funds typically have a low overlap of securities. That's why our funds can be used to build truly diversified portfolios 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 account services that have helped us become one of the most trusted names in financial services. MUTUAL FUNDS | RETIREMENT PLANS | 529 COLLEGE SAVINGS PLANS | SEPARATE ACCOUNTS [GRAPHIC OMITTED] Not part of the annual report Contents SHAREHOLDER LETTER .................... 1 ANNUAL REPORT Franklin Strategic Mortgage Portfolio . 3 Performance Summary ................... 6 Financial Highlights and Statement of Investments .............. 8 Financial Statements .................. 13 Notes to Financial Statements ......... 16 Independent Auditors' Report .......... 21 Board Members and Officers ............ 22 Proxy Voting Policies and Procedures .. 27 Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO YOUR FUND'S GOAL AND PRIMARY INVESTMENTS: Franklin Strategic Mortgage Portfolio seeks to obtain a high level of total return relative to the performance of the general mortgage securities market by investing at least 80% of its net assets in a portfolio of mortgage securities created from pools of mortgages issued or guaranteed by the U.S. government, its agencies or instrumentalities. 1 We are pleased to bring you Franklin Strategic Mortgage Portfolio's annual report for the fiscal year ended September 30, 2003. PERFORMANCE OVERVIEW For the 12 months under review, Franklin Strategic Mortgage Portfolio - Class A delivered a +3.40% cumulative total return, as shown in the Performance Summary beginning on page 6. In comparison, the Fund's benchmark Citigroup Mortgage-Backed Securities Index returned 3.49% and the Lipper U.S. Mortgage Funds Average returned 3.03% for the same period. 2 In addition, the Fund's return compared favorably with the Lehman Brothers Treasury Index's 3.26% return for the 12-month period. Notably, from the June 13 interest rate low through September PORTFOLIO BREAKDOWN Based on Total Long-Term Investments -------------------------------------------------------------------------------- 9/30/03 9/30/02 -------------------------------------------------------------------------------- 30-Year Mortgage Pass-Throughs 61.9% 57.4% -------------------------------------------------------------------------------- Adjustable Rate Mortgage 15.5% 14.3% -------------------------------------------------------------------------------- 15-Year Mortgage Pass-Throughs 14.5% 11.6% -------------------------------------------------------------------------------- Home Equity Loans &Manufactured Housing ABS 8.1% 16.7% -------------------------------------------------------------------------------- 1. U.S. government securities owned by the Fund or held under repurchase agreement, but not shares of the Fund, are guaranteed by the U.S. government as to the timely payment of principal and interest. Yield and share price are not guaranteed and will fluctuate with market conditions. 2. Sources: Standard & Poor's Micropal, Lipper Inc. The unmanaged Citigroup Mortgage-Backed Securities Index is a total return index that includes approximately 178 GNMA, FNMA and FHLMC issues. The index includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the Fund's portfolio. As of 9/30/03, the Lipper U.S. Mortgage Funds Average consisted of 79 funds. Lipper calculations do not include sales charges. The Fund's performance relative to the average might have differed if such charges had been considered. Past performance does not guarantee future results. THE DOLLAR VALUE, NUMBER OF SHARES OR PRINCIPAL AMOUNT, AND COMPLETE LEGAL TITLES OF ALL PORTFOLIO HOLDINGS ARE LISTED IN THE FUND'S STATEMENT OF INVESTMENTS (SOI). THE SOI BEGINS ON PAGE 9. Annual Report | 3 DIVIDEND DISTRIBUTIONS* 10/1/02-9/30/03 -------------------------------------------------------------------------------- MONTH DIVIDEND PER SHARE -------------------------------------------------------------------------------- October 4.4730 cents -------------------------------------------------------------------------------- November 4.7349 cents -------------------------------------------------------------------------------- December 4.8168 cents -------------------------------------------------------------------------------- January 4.4543 cents -------------------------------------------------------------------------------- February 4.2205 cents -------------------------------------------------------------------------------- March 4.1745 cents -------------------------------------------------------------------------------- April 4.2611 cents -------------------------------------------------------------------------------- May 4.4381 cents -------------------------------------------------------------------------------- June 4.8568 cents -------------------------------------------------------------------------------- July 4.5538 cents -------------------------------------------------------------------------------- August 4.3839 cents -------------------------------------------------------------------------------- September 4.8196 cents -------------------------------------------------------------------------------- TOTAL 54.1873 CENTS *Assumes shares were purchased and held for the entire accrual period. Since dividends accrue daily, your actual distributions will vary depending on the date you purchased your shares and any account activity during the month. Income distributions include all accrued income earned by the Fund during the reporting period. 30, 2003, the Fund returned 0.26% compared with the Lehman Brothers Treasury Index's -3.02% return. 3 ECONOMIC AND MARKET OVERVIEW Uncertainty about the economy's strength and geopolitical events pushed interest rates down during the first part of the reporting period. By mid-June, 10-year U.S. Treasury yields fell to 3.11%, the lowest level in more than 45 years. For consumers, historically low mortgage rates enabled many homeowners to refinance their mortgages, and refinancing applications reached their highest levels on record. Prepayments on mortgage-backed securities increased as well. Additionally, refinancing activity, stabilized equity markets, rising home values and improved consumer net worths allowed consumers to continue spending. In fact, retail sales grew 7.5% in September 2003 from a year earlier, helping the economy expand. Many businesses took the opportunity of a lower interest rate environment to refinance their old debt at more attractive levels. This helped enhance business operating performance. Credit-related fixed income products also benefited from this improvement. Additionally, businesses continued to achieve productivity gains by reducing their labor forces and taking advantage of recent technology investments. Higher productivity levels helped dampen inflation. In fact, core inflation (excluding food and energy) for September 2003 increased at a rate of 1.2% compared with the same month a year earlier. Expectations for continued low inflation contributed to a historically lower overall interest rate environment during the period. As some of the immediate perceived risks related to the Iraq war subsided in late spring, and economic activity and domestic equity markets rebounded, interest rates rose as investors tolerated more risk in their portfolios. Rising interest rates led to higher mortgage rates, and prepayments declined. INVESTMENT STRATEGY We invest at least 80% of total net assets in mortgage-backed securities and mortgage-related securities. At least 65% of total net assets are invested in securities rated AAA by Standard & Poor's or Moody's Investors Service, or if unrated, will be deemed of comparable quality by the Fund's manager. We analyze securities using proprietary models to help identify attractive investment opportunities. 3. Source: Standard &Poor's Micropal. The Lehman Brothers Treasury Index is the U.S. Treasury component of the Lehman Brothers U.S. Government Index. 4 | Annual Report MANAGER'S DISCUSSION During the Fund's fiscal year, we uncovered areas of the agency mortgage-backed securities markets where prepayment risk seemed mispriced. This led us primarily to securities with 5% to 7% coupons, although we looked for higher-coupon opportunities at attractive values. Seeking to help increase yield, we also purchased some higher-quality, mortgage-related, asset-backed securities as such securities typically carry a yield premium over their government-guaranteed counterparts. During periods of stable or rising interest rates, mortgages tend to outperform similar maturity Treasuries. As 10-year U.S. Treasury yields rose 33 basis points during the reporting period, the Fund's higher returns compared with those of similar maturity Treasuries reflected this propensity. Thank you for your continued participation in Franklin Strategic Mortgage Portfolio. We look forward to serving your future investment needs. [PHOTO OMITTED] /S/ ROGER A. BAYSTON Roger A. Bayston Portfolio Manager Franklin Strategic Mortgage Portfolio THIS DISCUSSION REFLECTS OUR ANALYSIS, OPINIONS AND PORTFOLIO HOLDINGS AS OF SEPTEMBER 30, 2003, THE END OF THE REPORTING PERIOD. OUR STRATEGIES AND THE FUND'S PORTFOLIO COMPOSITION WILL CHANGE DEPENDING ON 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 ADVISOR 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 | 5 PERFORMANCE SUMMARY AS OF 9/30/03 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 due on Fund dividends, capital gain distributions, if any, or any realized gains on the sale of Fund shares. Total return reflects the Fund's dividend income, capital gain distributions, if any, and any unrealized gains or losses. PRICE AND DISTRIBUTION INFORMATION
------------------------------------------------------------------------------------------------- CLASS A CHANGE 9/30/03 9/30/02 ------------------------------------------------------------------------------------------------- Net Asset Value (NAV) -$0.29 $10.07 $10.36 ------------------------------------------------------------------------------------------------- DISTRIBUTIONS (10/1/02-9/30/03) ------------------------------------------------------------------------------------------------- Dividend Income $0.541873 ------------------------------------------------------------------------------------------------- Short-Term Capital Gain $0.084700 ------------------------------------------------------------------------------------------------- Long-Term Capital Gain $0.006300 ------------------------------------------------------------------------------------------------- TOTAL $0.632873
Franklin Strategic Mortgage Portfolio paid distributions derived from long-term capital gains of 0.63 cents ($0.0063) per share in December 2002. The Fund hereby designates such distributions as capital gain dividends per Internal Revenue Code Section 852 (b)(3). PERFORMANCE 1
------------------------------------------------------------------------------------------------- CLASS A 1-YEAR 5-YEAR 10-YEAR ------------------------------------------------------------------------------------------------- Cumulative Total Return 2 +3.40% +38.15% +94.30% ------------------------------------------------------------------------------------------------- Average Annual Total Return 3 -0.99% +5.75% +6.41% ------------------------------------------------------------------------------------------------- Distribution Rate 4 5.22% ------------------------------------------------------------------------------------------------- 30-Day Standardized Yield 5 1.28%
ONGOING MARKET VOLATILITY CAN SIGNIFICANTLY AFFECT SHORT-TERM PERFORMANCE; MORE RECENT RETURNS MAY DIFFER FROM THOSE SHOWN. SINCE MARKETS CAN GO DOWN AS WELL AS UP, INVESTMENT RETURN AND PRINCIPAL VALUE WILL FLUCTUATE WITH MARKET CONDITIONS, AND YOU MAY HAVE A GAIN OR LOSS WHEN YOU SELL YOUR SHARES. FOR MORE CURRENT PERFORMANCE, SEE "FUNDS AND PERFORMANCE" AT FRANKLINTEMPLETON.COM OR CALL 1-800/342-5236. 6 | Past performance does not guarantee future results. | Annual Report PERFORMANCE SUMMARY (CONTINUED) TOTAL RETURN INDEX COMPARISON FOR HYPOTHETICAL $10,000 INVESTMENT 1 Total return represents the change in value of an investment over the periods shown. It includes the current, applicable, maximum sales charge, Fund expenses, account fees and reinvested distributions. The unmanaged index includes reinvested dividends. It differs from the Fund in composition and does not pay management fees or expenses. One cannot invest directly in an index. [GRAPHIC OMITTED] EDGAR REPRESENTATION OF DATA POINTS USED INPRINTED GRAPHIC AS FOLLOWS: Franklin Strategic Citigroup Mortgage-Backed Mortgage Portfolio Securities Index 6 10/93 $9579 $10000 9625 10034 9548 10016 9640 10090 9752 10192 9600 10128 9408 9878 9359 9816 9384 9850 9352 9824 9526 10016 9554 10038 9425 9902 9403 9900 9378 9864 9464 9946 9657 10170 9905 10429 9938 10471 10069 10611 10397 10954 10460 11012 10475 11034 10581 11136 10676 11236 10786 11140 10904 11472 11030 11614 11123 11703 11034 11611 10985 11571 4/96 10957 11518 10923 11503 11050 11650 11102 11696 11099 11698 11283 11895 11502 12126 11663 12293 11618 12238 11698 12342 11720 12355 11678 12253 11844 12439 11948 12556 12068 12700 12261 12935 12253 12912 12393 13066 12514 13206 12545 13251 12661 13372 12780 13497 12810 13538 12856 13591 12921 13667 13013 13763 13088 13824 13147 13892 13283 14018 13473 14186 10/98 13475 14170 13558 14236 13618 14307 13698 14405 13630 14352 13708 14451 13767 14522 13676 14425 13640 14391 13561 14293 13551 14284 13783 14528 13843 14605 13856 14617 13820 14569 13712 14458 13866 14628 14007 14785 14027 14792 14040 14804 14332 15123 14430 15220 14653 15444 14830 15610 14941 15725 15168 15958 15469 16214 15690 16466 15781 16557 15887 16664 4/01 15903 16682 15994 16785 16062 16808 16331 17121 16471 17277 16699 17532 16915 17770 16811 17607 16764 17543 16918 17716 17085 17909 16907 17728 17240 18058 17361 18191 17512 18338 17719 18545 17850 18708 18000 18844 18060 18915 18056 18898 18247 19097 18291 19151 18402 19282 18423 19276 18499 19349 18543 19359 18559 19400 18204 19050 18321 19174 9/03 18612 19502 ENDNOTES THE FUND'S SHARE PRICE AND YIELD MAY BE AFFECTED BY INTEREST RATE MOVEMENTS AND MORTGAGE PREPAYMENTS. SECURITIES OWNED BY THE FUND BUT NOT SHARES OF THE FUND, ARE GUARANTEED BY THE U.S. GOVERNMENT AS TO TIMELY PAYMENT OF PRINCIPAL AND INTEREST. THE FUND'S PROSPECTUS ALSO INCLUDES A DESCRIPTION OF THE MAIN INVESTMENT RISKS. CLASS A: Subject to the current, maximum 4.25% initial sales charge. Prior to 7/1/94, Fund shares were offered at a higher initial sales charge; thus actual total returns would be lower. 1. Past expense reductions by the Fund's manager increased the Fund's total returns. Without these reductions, 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 and does not include the sales charge. 3. Average annual total return represents the average annual change in value of an investment over the periods indicated and includes the current, maximum sales charge. 4. Distribution rate is based on an annualization of September's 4.8196 cent per share dividend and the maximum offering price of $10.52 on 9/30/03. 5. Yield, calculated as required by the SEC, is based on the earnings of the Fund's portfolio for the 30 days ended 9/30/03. 6. Source: Standard & Poor's Micropal. The Citigroup Mortgage-Backed Securities Index is a total return index that includes 178 GNMA, FNMA and FHLMC issues. The index changed its name from Salomon Brothers Mortgage-Backed Securities Index in April 2003. Annual Report | Past performance does not guarantee future results. | 7 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO FINANCIAL HIGHLIGHTS
--------------------------------------------------------- YEAR ENDED SEPTEMBER 30, 2003 2002 2001 2000 1999 --------------------------------------------------------- PER SHARE OPERATING PERFORMANCE (for a share outstanding throughout the year) Net asset value, beginning of year .................................. $10.36 $10.27 $ 9.77 $9.74 $10.14 --------------------------------------------------------- Income from investment operations: Net investment income a ............................................ .285 .488 .657 .663 .627 Net realized and unrealized gains (losses) ......................... .048 .280 .539 .043 (.400) --------------------------------------------------------- Total from investment operations .................................... .333 .768 1.196 .706 .227 --------------------------------------------------------- Less distributions from: Net investment income .............................................. (.542) (.596) (.693) (.676) (.627) Realized capital gain .............................................. (.091) (.082) -- -- -- --------------------------------------------------------- Total distributions ................................................. (.633) (.678) (.693) (.676) (.627) --------------------------------------------------------- Net asset value, end of year ........................................ $10.06 $10.36 $10.27 $9.77 $ 9.74 --------------------------------------------------------- Total return b ...................................................... 3.40% 7.79% 12.60% 7.60% 2.30% RATIOS/SUPPLEMENTAL DATA Net assets, end of year (000's) ..................................... $421,827 $407,701 $188,330 $49,572 $32,877 Ratios to average net assets: Expenses ........................................................... .52% .25% --% --% --% Expenses excluding waiver and payments by affiliate ................ .52% .54% .64% .63% .70% Net investment income .............................................. 2.79% 4.78% 5.98% 6.87% 6.32% Portfolio turnover rate ............................................. 288.41% 219.99% 310.95% 226.43% 43.70% Portfolio turnover rate excluding mortgage dollar rolls c ........... 125.17% 87.47% 87.91% 42.00% 41.72%
aBased on average shares outstanding. bTotal return does not reflect sales commissions and is not annualized for periods less than one year. cSee Note 1(f) regarding mortgage dollar rolls. 8 | See notes to financial statements. | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2003
-------------------------------------------------------------------------------------------------------------------------- PRINCIPAL AMOUNT VALUE -------------------------------------------------------------------------------------------------------------------------- FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) 37.8% FHLMC, 5.00%, 10/01/17 - 8/01/33 .................................................... $ 23,953,587 $ 24,221,642 FHLMC, 6.00%, 10/01/19 - 9/01/33 .................................................... 36,508,153 37,756,375 FHLMC, 6.50%, 3/01/09 - 9/01/32 ..................................................... 8,784,452 9,183,270 FHLMC, 7.00%, 6/01/09 - 7/01/32 ..................................................... 11,435,312 12,089,274 FHLMC, 7.50%, 4/01/10 - 8/01/32 ..................................................... 5,760,093 6,163,466 FHLMC, 8.00%, 4/01/08 - 5/01/30 ..................................................... 1,097,986 1,186,451 FHLMC, 8.50%, 2/01/17 - 9/01/30 ..................................................... 6,841,422 7,449,524 FHLMC, 9.00%, 7/01/08 - 9/01/30 ..................................................... 1,055,122 1,151,719 FHLMC, 9.25%, 12/01/08 - 8/01/14 .................................................... 262,876 280,777 FHLMC, 9.50%, 12/01/16 - 4/01/25 .................................................... 4,658,064 5,197,877 FHLMC, 10.00%, 1/01/19 .............................................................. 880,862 996,968 FHLMC, 4.50%, 10/01/18 .............................................................. 16,475,000 16,624,296 FHLMC, 5.00%, 10/01/33 .............................................................. 16,975,000 16,975,000 FHLMC, 5.50%, 10/01/33 .............................................................. 18,100,000 18,462,000 FHLMC, 6.00%, 1/01/32 ............................................................... 1,372,168 1,418,228 FHLMC, 9.125%, 9/01/17 .............................................................. 5,082 5,636 -------------- 159,162,503 -------------- FEDERAL HOME LOAN MORTGAGE CORP. (FHLMC) - ADJUSTABLE RATE 6.9% FHLMC, ARM, 3.125%, 4/01/17 ......................................................... 177,016 179,500 FHLMC, ARM, 3.368%, 10/01/18 ........................................................ 586,343 602,821 FHLMC, ARM, 3.411%, 5/01/20 ......................................................... 738,271 756,838 FHLMC, ARM, 3.449%, 3/01/19 ......................................................... 499,139 515,958 FHLMC, ARM, 3.538%, 5/01/22 ......................................................... 384,753 392,290 FHLMC, ARM, 3.617%, 9/01/27 ......................................................... 550,658 568,024 FHLMC, ARM, 3.625%, 4/01/18 ......................................................... 566,098 583,794 FHLMC, ARM, 3.646%, 11/01/25 ........................................................ 1,154,577 1,189,215 FHLMC, ARM, 3.745%, 7/01/22 ......................................................... 3,746,601 3,850,493 FHLMC, ARM, 3.885%, 11/01/16 ........................................................ 1,091,353 1,114,360 FHLMC, ARM, 4.123%, 12/01/30 ........................................................ 480,503 500,852 FHLMC, ARM, 4.243%, 7/01/24 ......................................................... 614,132 631,732 FHLMC, ARM, 5.233%, 1/01/32 ......................................................... 2,061,560 2,120,919 FHLMC, ARM, 5.237%, 5/01/30 ......................................................... 1,292,288 1,340,411 FHLMC, ARM, 5.697%, 11/01/25 ........................................................ 227,477 233,667 FHLMC, ARM, 6.094%, 4/01/24 ......................................................... 716,555 737,850 FHLMC, ARM, 6.119%, 1/01/31 ......................................................... 1,562,922 1,607,416 FHLMC, ARM, 6.244%, 8/01/31 ......................................................... 683,167 706,078 FHLMC, ARM, 6.396%, 4/01/30 ......................................................... 7,397,519 7,613,354 FHLMC, ARM, 6.639%, 7/01/30 ......................................................... 1,561,199 1,633,685 FHLMC, ARM, 6.723%, 1/01/28 ......................................................... 1,020,166 1,045,824 FHLMC, ARM, 6.877%, 11/01/19 ........................................................ 631,097 673,943 FHLMC, ARM, 7.10%, 4/01/31 .......................................................... 582,922 596,256 -------------- 29,195,280 -------------- FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) 33.8% FNMA, 4.25%, 9/01/18 ................................................................ 124,084 125,901 FNMA, 5.00%, 7/01/18 - 10/01/33 ..................................................... 13,559,993 13,869,801 FNMA, 5.50%, 5/01/14 - 10/01/33 ..................................................... 55,070,674 56,366,817 FNMA, 6.00%, 1/01/11 - 2/01/33 ...................................................... 16,767,182 17,458,655 FNMA, 6.50%, 9/01/08 - 8/01/32 ...................................................... 33,261,961 34,717,344 FNMA, 7.00%, 7/01/09 - 10/01/32 ..................................................... 9,339,349 9,888,702
Annual Report | 9 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2003 (CONTINUED)
-------------------------------------------------------------------------------------------------------------------------- PRINCIPAL AMOUNT VALUE -------------------------------------------------------------------------------------------------------------------------- FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) (CONT.) FNMA, 7.50%, 7/01/09 - 5/01/32 ...................................................... $ 1,938,729 $ 2,070,185 FNMA, 8.00%, 7/01/16 - 7/01/31 ...................................................... 336,772 364,323 FNMA, 8.50%, 7/01/24 - 4/01/30 ...................................................... 905,490 988,173 FNMA, 9.00%, 8/01/09 - 9/01/26 ...................................................... 1,752,907 1,929,199 FNMA, 9.25%, 10/01/09 ............................................................... 28,724 30,569 FNMA, 9.50%, 11/01/15 - 4/01/30 ..................................................... 1,997,693 2,213,838 FNMA, 10.00%, 8/01/15 - 4/01/21 ..................................................... 1,779,082 2,011,344 FNMA, 10.50%, 1/01/16 - 5/01/30 ..................................................... 285,977 317,243 FNMA, 10.75%, 10/01/05 .............................................................. 2,028 2,062 FNMA, 11.00%, 10/01/15 - 6/01/30 .................................................... 235,252 269,809 FNMA, 11.25%, 2/01/16 ............................................................... 16,667 19,080 FNMA, 12.00%, 4/01/15 - 5/01/16 ..................................................... 9,395 10,801 FNMA, 12.50%, 9/01/13 - 12/01/13 .................................................... 2,684 3,113 -------------- 142,656,959 -------------- FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) - ADJUSTABLE RATE 10.4% FNMA, ARM, 3.074%, 7/01/17 .......................................................... 389,795 393,290 FNMA, ARM, 3.193%, 8/01/30 .......................................................... 885,171 918,249 FNMA, ARM, 3.203%, 4/01/18 .......................................................... 124,298 127,670 FNMA, ARM, 3.208%, 1/01/17 .......................................................... 1,044,345 1,082,566 FNMA, ARM, 3.292%, 7/01/27 .......................................................... 369,405 381,057 FNMA, ARM, 3.355%, 4/01/21 .......................................................... 248,369 256,394 FNMA, ARM, 3.363%, 1/01/18 .......................................................... 4,331,279 4,393,495 FNMA, ARM, 3.423%, 12/01/22 ......................................................... 591,106 608,850 FNMA, ARM, 3.526%, 10/01/29 ......................................................... 702,101 724,143 FNMA, ARM, 3.54%, 7/01/19 ........................................................... 142,959 146,002 FNMA, ARM, 3.605%, 8/01/29 .......................................................... 515,406 534,495 FNMA, ARM, 3.722%, 7/01/14 .......................................................... 1,068,489 1,101,093 FNMA, ARM, 3.735%, 4/01/27 .......................................................... 673,317 691,772 FNMA, ARM, 3.742%, 7/01/19 .......................................................... 4,450,662 4,592,059 FNMA, ARM, 3.754%, 5/01/25 .......................................................... 133,183 137,895 FNMA, ARM, 3.876%, 6/01/25 .......................................................... 300,031 309,804 FNMA, ARM, 3.928%, 8/01/27 .......................................................... 184,955 190,370 FNMA, ARM, 4.041%, 7/01/25 .......................................................... 325,931 335,660 FNMA, ARM, 4.056%, 10/01/24 ......................................................... 1,218,957 1,252,112 FNMA, ARM, 4.074%, 10/01/29 ......................................................... 1,979,197 2,032,662 FNMA, ARM, 4.613%, 5/01/27 .......................................................... 3,115,732 3,197,636 FNMA, ARM, 4.878%, 10/01/19 ......................................................... 929,956 967,207 FNMA, ARM, 5.218%, 12/01/31 ......................................................... 1,047,402 1,075,463 FNMA, ARM, 5.246%, 8/01/32 .......................................................... 877,323 914,008 FNMA, ARM, 5.377%, 2/01/32 .......................................................... 1,184,954 1,225,092 FNMA, ARM, 5.568%, 6/01/17 .......................................................... 265,791 276,217 FNMA, ARM, 5.57%, 7/01/26 ........................................................... 123,721 125,075 FNMA, ARM, 5.622%, 1/01/32 .......................................................... 601,960 616,987 FNMA, ARM, 5.637%, 5/01/30 .......................................................... 461,519 477,781 FNMA, ARM, 5.753%, 8/01/26 .......................................................... 1,235,929 1,284,971 FNMA, ARM, 5.895%, 5/01/21 .......................................................... 1,041,485 1,079,117 FNMA, ARM, 5.937%, 4/01/18 .......................................................... 464,978 481,859 FNMA, ARM, 5.94%, 7/01/31 ........................................................... 794,949 823,498 FNMA, ARM, 5.994%, 10/01/32 ......................................................... 929,778 956,507
10 | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2003 (CONTINUED)
-------------------------------------------------------------------------------------------------------------------------- PRINCIPAL AMOUNT VALUE -------------------------------------------------------------------------------------------------------------------------- FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA) - ADJUSTABLE RATE (CONT.) FNMA, ARM, 6.034%, 6/01/31 .......................................................... $ 1,694,933 $ 1,744,825 FNMA, ARM, 6.075%, 11/01/28 ......................................................... 721,773 741,747 FNMA, ARM, 6.086%, 5/01/28 .......................................................... 1,724,071 1,768,250 FNMA, ARM, 6.11%, 8/01/29 ........................................................... 313,414 322,535 FNMA, ARM, 6.121%, 5/01/31 .......................................................... 279,623 289,024 FNMA, ARM, 6.255%, 12/01/24 ......................................................... 273,254 282,381 FNMA, ARM, 6.42%, 4/01/31 ........................................................... 740,233 765,869 FNMA, ARM, 6.843%, 7/01/31 .......................................................... 3,377,710 3,483,170 FNMA, ARM, 7.022%, 9/01/32 .......................................................... 686,945 708,374 FNMA, ARM, 8.485%, 6/01/30 .......................................................... 233,032 246,302 -------------- 44,063,533 -------------- GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), SF, 16.3% GNMA, 5.50%, 7/15/33 - 10/01/33 ..................................................... 16,987,500 17,427,565 GNMA, 6.00%, 2/15/29 - 1/15/33 ...................................................... 4,087,530 4,251,541 GNMA, 6.50%, 1/15/24 - 8/15/32 ...................................................... 12,897,154 13,540,260 GNMA, 7.00%, 10/15/09 - 11/20/32 .................................................... 14,765,567 15,687,249 GNMA, 7.50%, 6/20/17 - 7/20/32 ...................................................... 8,531,098 9,073,036 GNMA, 8.00%, 9/15/15 - 1/15/28 ...................................................... 2,858,400 3,110,701 GNMA, 8.25%, 6/15/04 - 10/15/21 ..................................................... 903,703 984,046 GNMA, 8.50%, 6/15/16 - 8/15/26 ...................................................... 1,952,831 2,152,363 GNMA, 9.00%, 11/15/04 - 8/15/28 ..................................................... 579,563 632,855 GNMA, 9.50%, 10/15/09 - 10/15/20 .................................................... 310,904 340,634 GNMA, 10.00%, 10/15/18 - 2/15/19 .................................................... 47,138 53,455 GNMA, 10.50%, 1/15/16 ............................................................... 1,342 1,530 GNMA II, 6.50%, 1/20/26 - 6/20/27 ................................................... 794,541 833,854 GNMA II, 7.00%, 9/20/27 ............................................................. 237,992 252,814 GNMA II, 7.50%, 11/20/22 - 1/20/23 .................................................. 490,328 524,709 GNMA II, 8.00%, 8/20/26 ............................................................. 2,258 2,434 GNMA II, 9.00%, 9/20/24 - 11/20/24 .................................................. 20,007 22,052 GNMA II, 10.50%, 6/20/20 ............................................................ 310 353 -------------- 68,891,451 -------------- GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA), ADJUSTABLE RATE, SF, .4% GNMA, ARM, 5.625%, 11/20/25 ......................................................... 386,749 402,577 GNMA, ARM, 5.750%, 7/20/27 .......................................................... 1,114,593 1,147,931 -------------- 1,550,508 -------------- HOME EQUITY ASSET-BACKED SECURITIES 9.3% AFC Home Equity Loan Trust, 1.36%, 12/22/27 ......................................... 3,051,119 3,048,378 Ameriquest Mortgage Securities Co., AQ1, M1, 6.863%, 8/25/16 ........................ 6,000,000 6,228,487 Chase Funding Mortgage Loan Asset Backed CTFS, 1.365%, 9/25/29 ...................... 726,544 727,764 Citifinancial Mortgage Securities Inc., 1, AF3, 4.001%, 2/21/30 ..................... 4,000,000 4,084,918 Contimortgage Home Equity Loan Trust, 1, A6, 6.69%, 1/15/16 ............................................................ 106,341 106,331 3, A6, 7.68%, 12/25/29 ........................................................... 820,000 883,173 Countrywide Home Loan, 12, 1A1, 5.25%, 8/25/32 ...................................... 1,030,545 1,033,377 Fannie Mae Whole Loan, W2, AF3, 5.258%, 5/25/29 ..................................... 102,384 102,375 Morgan Stanley Capital I, 2002-NC4, A2, 1.51%, 9/25/32 ..................................................... 4,240,477 4,246,895 2003-NC3, M1, 2.01%, 3/25/33 ..................................................... 10,000,000 10,060,995
Annual Report | 11 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO STATEMENT OF INVESTMENTS, SEPTEMBER 30, 2003 (CONTINUED)
-------------------------------------------------------------------------------------------------------------------------- PRINCIPAL AMOUNT VALUE -------------------------------------------------------------------------------------------------------------------------- HOME EQUITY ASSET-BACKED SECURITIES (CONT.) Residential Asset Securities Corp., 1.37%, 3/25/30 .................................. $ 5,001,581 $ 4,999,511 Residential Funding Mortgage Securities, 4.04%, 7/25/15 ............................. 2,500,000 2,582,313 Saxon Asset Security Trust, 5.564%, 8/25/16 ......................................... 1,107,043 1,112,181 -------------- 39,216,698 -------------- MISCELLANEOUS MORTGAGE-BACKED SECURITIES .1% Travelers Mortgage Services Inc., 4.118%, 12/25/18 .................................. 354,528 354,527 Vanderbilt Mortgage Finance, 6.75%, 10/07/28 ........................................ 100,000 96,463 -------------- 450,990 -------------- TOTAL LONG TERM INVESTMENTS (COST $480,494,275) ..................................... 485,187,922 -------------- SHORT TERM INVESTMENTS 9.3% a Joint Repurchase Agreement, .976%, 10/01/03, (Maturity Value $17,962,349) ........... 17,961,862 17,961,862 ABN Amro Inc. (Maturity Value $1,651,436) Banc of America Securities LLC., (Maturity Value $1,651,436) Barclays Capital Inc. (Maturity Value $1,651,436) Bear Stearns & Co. Inc. (Maturity Value $1,016,268) Dresdner Kleinwort Benson, North America LLC (Maturity Value $1,778,469) Deutsche Bank Securities (Maturity Value $1,651,436) Goldman Sachs & Co. (Maturity Value $1,651,436) Greenwich Capital Markets (Maturity Value $1,651,436) Lehman Brothers Inc. (Maturity Value $304,688) Morgan Stanley & Co. Inc. (Maturity Value $1,651,436) Paribas Corp. (Maturity Value $1,651,436) UBS Warburg LLC (Maturity Value $1,651,436) Collateralized by U.S. Treasury Bills, Notes and Bonds, and U.S. Government Agency Securities U.S. Treasury Bill, .875%, 11/13/03 ................................................... 200,000 199,802 -------------- SHARES -------------- b Franklin Institutional Fiduciary Trust Money Market Portfolio ....................... 21,020,022 21,020,022 -------------- TOTAL SHORT TERM INVESTMENTS (COST $39,181,161) ..................................... 39,181,686 -------------- TOTAL INVESTMENTS BEFORE PAYDOWN RESERVE 124.3% ..................................... 524,369,608 c RESERVE FOR PAYDOWN GAINS (LOSSES) (.3)% ............................................ (1,401,680) -------------- TOTAL INVESTMENTS (COST $519,675,936) 124.0% ........................................ 522,967,928 OTHER ASSETS, LESS LIABILITIES (24.0)% .............................................. (101,140,984) -------------- NET ASSETS 100.0% ................................................................... $ 421,826,944 --------------
PORTFOLIO ABBREVIATIONS | ARM - Adjustable Rate Mortgage | SF - Single Family aSee Note 1(b) regarding joint repurchase agreement. bSee Note 6 regarding investments in the Franklin Institutional Fiduciary Trust Money Market Portfolio. cSee Note 1(d) regarding reserve for paydown. 12 | See notes to financial statements. | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO FINANCIAL STATEMENTS STATEMENT OF ASSETS AND LIABILITIES September 30, 2003
Assets: Investments in securities: Cost .......................................................................... $519,675,936 ------------- Value ......................................................................... 522,967,928 Cash ........................................................................... 1,971,062 Receivables: Investment securities sold .................................................... 1,605,664 Capital shares sold ........................................................... 352,841 Dividends and interest ........................................................ 1,930,740 ------------- Total assets .............................................................. 528,828,235 ------------- Liabilities: Payables: Investment securities purchased ............................................... 104,741,182 Capital shares redeemed ....................................................... 1,563,759 Affiliates .................................................................... 162,028 Shareholders .................................................................. 31,510 Distributions to shareholders .................................................. 434,929 Other liabilities .............................................................. 67,883 ------------- Total liabilities ......................................................... 107,001,291 ------------- Net assets, at value ..................................................... $421,826,944 ------------- Net assets consist of: Undistributed net investment income ............................................ $ (472,622) Net unrealized appreciation (depreciation) ..................................... 3,291,992 Accumulated net realized gain (loss) ........................................... (5,883,305) Capital shares ................................................................. 424,890,879 ------------- Net assets, at value ..................................................... $421,826,944 ------------- Net asset value per share a ($421,826,944 / 41,911,767 shares outstanding) ..... $10.06 ------------- Maximum offering price per share ($10.06 / 95.75%) ............................. $10.51 -------------
aRedemption price is equal to net asset value less any applicable contingent deferred sales charge. Annual Report | See notes to financial statements. | 13 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO FINANCIAL STATEMENTS (CONTINUED) STATEMENT OF OPERATIONS for the year ended September 30, 2003
Investment income: Dividends ..................................................................... $ 204,021 Interest ...................................................................... 14,206,739 ------------ Total investment income .................................................. 14,410,760 ------------ Expenses: Management fees (Note 3) ...................................................... 1,634,993 Transfer agent fees (Note 3) .................................................. 455,806 Custodian fees ................................................................ 5,521 Reports to shareholders ....................................................... 32,066 Registration and filing fees .................................................. 87,588 Professional fees ............................................................. 31,910 Other ......................................................................... 32,876 ------------ Total expenses ........................................................... 2,280,760 ------------ Net investment income ................................................... 12,130,000 ------------ Realized and unrealized gains (losses): Net realized gain (loss) from: Investments .................................................................. 5,898,905 Financials futures contracts ................................................. 110,382 ------------ Net realized gain (loss) ...................................................... 6,009,287 ------------ Net unrealized appreciation (depreciation) on investments ..................... (3,978,112) ------------ Net realized and unrealized gain (loss) ........................................ 2,031,175 ------------ Net increase (decrease) in net assets resulting from operations ................ $14,161,175 ------------
14 | See notes to financial statements. | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF CHANGES IN NET ASSETS for the years ended September 30, 2003 and 2002
------------------------------ 2003 2002 ------------------------------ Increase (decrease) in net assets: Operations: Net investment income ................................................................. $ 12,130,000 $ 13,744,630 Net realized gain (loss) from investments and financial futures ....................... 6,009,287 5,715,234 Net unrealized appreciation (depreciation) on investments ............................. (3,978,112) 3,699,755 ------------------------------ Net increase (decrease) in net assets resulting from operations ....................... 14,161,175 23,159,619 Distributions to shareholders from: Net investment income ................................................................. (23,092,475) (16,591,328) Net realized gains .................................................................... (3,766,405) (1,823,534) ------------------------------ Total distributions to shareholders .................................................. (26,858,880) (18,414,862) Capital share transactions (Note 2) .................................................. 26,823,466 214,626,197 ------------------------------ Net increase (decrease) in net assets ................................................... 14,125,761 219,370,954 Net assets: Beginning of year ...................................................................... 407,701,183 188,330,229 ------------------------------ End of year ............................................................................ $421,826,944 $ 407,701,183 ------------------------------ Undistributed net investment income included in net assets: End of year ............................................................................ $ (472,622) $ (260,494) ------------------------------
Annual Report | See notes to financial statements. | 15 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Franklin Strategic Mortgage Portfolio (the Trust) is registered under the Investment Company Act of 1940 as a diversified, open-end investment company, consisting of one Fund, the Franklin Strategic Mortgage Portfolio (the Fund). The Fund seeks total return. The following summarizes the Fund's significant accounting policies. A. SECURITY VALUATION Securities listed or traded on a recognized national exchange or NASDAQ are valued at the last reported sales price. Over-the-counter securities and listed securities for which no sale is reported are valued within the range of the latest quoted bid and asked prices. Securities for which market quotations are not readily available are valued at fair value as determined by management in accordance with procedures established by the Board of Trustees. B. JOINT REPURCHASE AGREEMENT The Fund may enter into a joint repurchase agreement whereby its uninvested cash balance is deposited into a joint cash account to be used to invest in one or more repurchase agreements. The value and face amount of the joint repurchase agreement are allocated to the Fund based on its pro-rata interest. A repurchase agreement is accounted for as a loan by the Fund to the seller, collateralized by securities which are delivered to the Fund's custodian. The market value, including accrued interest, of the initial collateralization is required to be at least 102% of the dollar amount invested by the Fund, with the value of the underlying securities marked to market daily to maintain coverage of at least 100%. At September 30, 2003, all repurchase agreements had been entered into on that date. C. 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. D. RESERVE FOR PAYDOWN GAINS/LOSSES The Fund provides estimates, based on historical experience, for anticipated paydown gains and losses. The reserve is recorded as a reduction or increase to net assets as noted on the Statement of Investments and is included in the unrealized appreciation/depreciation shown on the accompanying financial statements. 16 | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) E. FUTURES CONTRACTS The Fund may purchase financial futures contracts to gain exposure to market changes. A financial futures contract is an agreement between two parties to buy or sell a security for a set price on a future date. Required initial margin deposits of cash or securities are maintained by the Fund's custodian in segregated accounts. Subsequent payments, known as variation margin, are made or received by the Fund depending on the fluctuations in the value of the underlying securities. Such variation margin is accounted for as unrealized gains or losses until the contract is closed, at which time the gains or losses are reclassified to realized. Realized and unrealized gains and losses are included in the Statement of Operations. The risks of these contracts include the possibility there may be an illiquid secondary market and/or a change in the value of the contract may not correlate with the changes in the value of the underlying securities. F. MORTGAGE DOLLAR ROLLS The Fund enters into mortgage dollar rolls, typically on a TBA basis. Dollar rolls are agreements between the Fund and a financial institution to simultaneously sell and repurchase a mortgage-backed security at a future date. Gains or losses are realized at the time of the sale and the difference between the repurchase price and sale price is recorded as an unrealized gain to the Fund. The risks of mortgage dollar roll transactions include the potential inability of the counterparty to fulfill their obligations. G. INCOME TAXES No provision has been made for income taxes because the Fund's policy is to qualify as a regulated investment company under the Internal Revenue Code and to distribute substantially all of its tax- able income. 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 and distributed monthly to shareholders. 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 expense during the reporting period. Actual results could differ from those estimates. Annual Report | 17 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) J. GUARANTEES AND INDEMNIFICATIONS Under the Fund's organizational documents, its officers and trustees are indemnified against certain liability arising out of the performance of their duties to the Fund. Additionally, in the normal course of business, the Fund enters into contracts with service providers that contain general indemnification clauses. The Fund's maximum exposure under these arrangements is unknown as this would involve future claims that may be made against the Fund that have not yet occurred. However, based on experience, the Fund expects the risk of loss to be remote. 2. SHARES OF BENEFICIAL INTEREST At September 30, 2003, there were an unlimited number of shares authorized ($0.01 par value). Transactions in the Fund's shares were as follows:
---------------------------------------------------------------- SEPTEMBER 30, 2003 2002 ---------------------------------------------------------------- SHARES AMOUNT SHARES AMOUNT ---------------------------------------------------------------- Shares sold ....................... 16,477,900 $ 168,508,139 27,397,407 $279,603,949 Shares issued in reinvestment of distributions ..................... 2,108,653 21,507,173 1,446,781 14,762,228 Shares redeemed ................... (16,044,902) (163,191,846) (7,806,806) (79,739,980) ---------------------------------------------------------------- Net increase ...................... 2,541,651 $ 26,823,466 21,037,382 $214,626,197 ----------------------------------------------------------------
3. TRANSACTIONS WITH AFFILIATES Certain officers and trustees of the Fund are also officers and/or directors of the following entities. ------------------------------------------------------------------------------ ENTITY AFFILIATION ------------------------------------------------------------------------------ Franklin Templeton Services, LLC (FT Services) Administrative manager Franklin Advisers, Inc. (Advisers) Investment manager Franklin/Templeton Distributers, Inc. (Distributors) Principal underwriter Franklin/Templeton Investor Services, LLC (Investor Services) Transfer agent The Fund pays an investment management fee to Advisers based on the average net assets of the Fund as follows: --------------------------------------------------------------------------- ANNUALIZED FEE RATE AVERAGE DAILY NET ASSETS --------------------------------------------------------------------------- .40% First $250 million .38% Over $250 million, up to and including $500 million .36% In excess of $500 million 18 | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO NOTES TO FINANCIAL STATEMENTS (CONTINUED) 3. TRANSACTIONS WITH AFFILIATES (CONTINUED) 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. Distributors received net commissions from sales of Fund shares, and received contingent deferred sales charges for the year of $45,605 and $14,398, respectively. The Fund paid transfer agent fees of $455,806, of which $255,334 was paid to Investor Services. 4. INCOME TAXES At September 30, 2003, the Fund has deferred capital losses occurring subsequent to October 31, 2002 of $5,873,670. For tax purposes, such losses will be reflected in the year ending September 30, 2004. The tax character of distributions paid during the years ended September 30, 2003 and 2002, were as follows: -------------------------- 2003 2002 -------------------------- Distributions paid from: Ordinary income .......................... $26,597,758 $18,414,862 Long-term capital gain ................... 261,122 -- -------------------------- $26,858,880 $18,414,862 -------------------------- At September 30, 2003, the cost of investments, net unrealized appreciation (depreciation), undistributed ordinary income and undistributed long term capital gains for income tax purposes were as follows: Cost of investments ..................................... $520,275,735 ------------- Unrealized appreciation ................................. 3,734,766 Unrealized depreciation ................................. (1,042,573) ------------- Net unrealized appreciation ............................. $ 2,692,193 ------------- Undistributed ordinary income ........................... $ 552,472 Undistributed long term capital gains ................... -- ------------- Distributable earnings .................................. $ 552,472 ------------- Net investment income (loss) differs for financial statement and tax purposes primarily due to differing treatments of mortgage dollar roll transactions and paydown losses. Net realized gains (losses) differ for financial statement and tax purposes primarily due to differing treatment of wash sales, mortgage dollar roll transactions, and paydown losses. Annual Report | 19 FRANKLIN STRATEGIC MORTGAGE PORTFOLIO NOTES TO FINANCIAL STATEMENTS (CONTINUED) 5. INVESTMENT TRANSACTIONS Purchases and sales of investments (excluding short-term securities) for the year ended September 30, 2003 aggregated $1,454,959,848 and $1,338,948,434 respectively. 6. INVESTMENTS IN FRANKLIN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO The Fund may invest in the Franklin Institutional Fiduciary Trust Money Market Portfolio (the 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 fees paid by the Sweep Money Fund. The Fund earned $204,021 of dividend income from investment in the Sweep Money Fund for the year ended September 30, 2003. 20 | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO INDEPENDENT AUDITORS' REPORT TO THE BOARD OF TRUSTEES AND SHAREHOLDERS OF FRANKLIN STRATEGIC MORTGAGE PORTFOLIO In our opinion, the accompanying statement of assets and liabilities, including the statement of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of Franklin Strategic Mortgage Portfolio (the "Fund") at September 30, 2003, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the periods presented, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as "financial statements") are the responsibility of the Fund's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at September 30, 2003 by correspondence with the custodian and brokers, provide a reasonable basis for our opinion. PricewaterhouseCoopers LLP San Francisco, California November 4, 2003 Annual Report | 21 Board Members and Officers The name, age 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. Each board member will serve until that person's successor is elected and qualified. INDEPENDENT BOARD MEMBERS
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ FRANK H. ABBOTT, III (82) Trustee Since 1992 115 None One Franklin Parkway San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: President and Director, Abbott Corporation (an investment company). ------------------------------------------------------------------------------------------------------------------------------------ HARRIS J. ASHTON (71) Trustee Since 1992 142 Director, Bar-S Foods (meat packing One Franklin Parkway company). 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). ------------------------------------------------------------------------------------------------------------------------------------ S. JOSEPH FORTUNATO (71) Trustee Since 1992 143 None One Franklin Parkway San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Attorney; and FORMERLY, member of the law firm of Pitney, Hardin, Kipp & Szuch. ------------------------------------------------------------------------------------------------------------------------------------ EDITH E. HOLIDAY (51) Trustee Since 92 Director, Amerada Hess Corporation One Franklin Parkway April 2003 (exploration and refining of oil and San Mateo, CA 94403-1906 gas); Beverly Enterprises, Inc. (health care); H.J. Heinz Company (processed foods and allied products); RTI International Metals, Inc. (manufacture and distribution of titanium); and Canadian National Railway (railroad). 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). ------------------------------------------------------------------------------------------------------------------------------------
22 | Annual Report
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ FRANK W.T. LAHAYE (74) Trustee Since 1992 115 Director, The California Center for Land One Franklin Parkway Recycling (redevelopment). San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: General Partner, Las Olas L.P. (Asset Management); and FORMERLY, Chairman, Peregrine Venture Management Company (venture capital). ------------------------------------------------------------------------------------------------------------------------------------ GORDON S. MACKLIN (75) Trustee Since 1998 142 Director, White Mountains Insurance One Franklin Parkway Group, Ltd. (holding company); Martek San Mateo, CA 94403-1906 Biosciences Corporation; MedImmune, Inc. (biotechnology); Overstock.com (Internet services); and Spacehab, Inc. (aerospace services); and FORMERLY, Director, MCI Communication Corporation (subsequently known as MCI WorldCom, Inc. and WorldCom, Inc.) (communications services) (1988-2002). PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Deputy Chairman, White Mountains Insurance Group, Ltd. (holding company); and FORMERLY, Chairman, White River Corporation (financial services) (1993-1998) and Hambrecht & Quist Group (investment banking) (1987-1992); and President, National Association of Securities Dealers, Inc.(1970-1987). ------------------------------------------------------------------------------------------------------------------------------------
INTERESTED BOARD MEMBERS AND OFFICERS
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ **HARMON E. BURNS (58) Trustee and Trustee since 38 None One Franklin Parkway Vice 1993 and San Mateo, CA 94403-1906 President Vice President since 1992 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Vice Chairman, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Vice President and Director, Franklin Templeton Distributors,Inc.; Executive Vice President, Franklin Advisers, Inc.; Director, Franklin Investment Advisory Services, 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 49 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------ **CHARLES B. JOHNSON (70) Trustee and Trustee since 142 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, Chief Executive Officer, Member - Office of the Chairman and Director, Franklin Resources, Inc.; Vice President, Franklin Templeton Distributors, Inc.; Director, Fiduciary Trust Company International; and officer and/or director or trustee, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 46 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------
Annual Report | 23
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ **RUPERT H. JOHNSON, JR. (63) Trustee, Trustee since 125 None One Franklin Parkway President and 1992, President San Mateo, CA 94403-1906 Chief since 1993 and Executive Chief 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.; Vice President and Director, Franklin Templeton Distributors, Inc.; Director, Franklin Advisers, Inc. and Franklin Investment Advisory Services, 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 49 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------ MARTIN L. FLANAGAN (43) Vice Since 1995 Not Applicable None One Franklin Parkway President San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: President, Franklin Resources, Inc.; Senior Vice President and Chief Financial Officer, Franklin Mutual Advisers, LLC; Executive Vice President, Chief Financial Officer and Director, Templeton Worldwide, Inc.; Executive Vice President and Chief Operating Officer, Templeton Investment Counsel, LLC; President and Director, Franklin Advisers, Inc.; Executive Vice President, Franklin Investment Advisory Services, Inc. and Franklin Templeton Investor Services, LLC; Chief Financial Officer, Franklin Advisory Services, LLC; Chairman, Franklin Templeton 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 49 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------ JIMMY D. GAMBILL (56) Senior Vice Since 2002 Not Applicable None 500 East Broward Blvd. President and Suite 2100 Chief Fort Lauderdale, FL 33394-3091Executive Officer - Finance and Administration PRINCIPAL OCCUPATION DURING PAST 5 YEARS: President, Franklin Templeton Services, LLC, and officer of some of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------
24 | Annual Report
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ DAVID P. GOSS (56) Vice President Since 2000 Not Applicable None One Franklin Parkway San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Associate General Counsel, Franklin Resources, Inc.; officer and director of one of the subsidiaries of Franklin Resources, Inc.; officer of 51 of the investment companies in Franklin Templeton Investments; and FORMERLY, President, Chief Executive Officer and Director, Property Resources Equity Trust (until 1999) and Franklin Select Realty Trust (until 2000). ------------------------------------------------------------------------------------------------------------------------------------ BARBARA J. GREEN (55) Vice President Since 2000 Not Applicable None One Franklin Parkway San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Vice President, Deputy General Counsel and Secretary, Franklin Resources, Inc.; Secretary and Senior Vice President, Templeton Worldwide, Inc.; Secretary, Franklin Advisers, Inc., Franklin Advisory Services, LLC, Franklin Investment Advisory Services, Inc., Franklin Mutual Advisers, LLC, Franklin Templeton Alternative Strategies, Inc., Franklin Templeton Investor Services, LLC, Franklin Templeton Services, LLC, Franklin Templeton Distributors, Inc., Templeton Investment Counsel, LLC, and Templeton/Franklin Investment Services, Inc.; and officer of some of the other subsidiaries of Franklin Resources, Inc. and of 51 of the investment companies in Franklin Templeton Investments; and FORMERLY, Deputy Director, Division of Investment Management, Executive Assistant and Senior Advisor to the Chairman, Counselor to the Chairman, Special Counsel and Attorney Fellow, U.S. Securities and Exchange Commission (1986-1995); Attorney, Rogers & Wells (until 1986); and Judicial Clerk, U.S. District Court (District of Massachusetts) (until 1979). ------------------------------------------------------------------------------------------------------------------------------------ MICHAEL O. MAGDOL (66) Vice Since 2002 Not Applicable Director, FTI Banque, Arch Chemicals, 600 Fifth Avenue President - Inc. and Lingnan Foundation Rockefeller Center AML New York, NY 10048-0772 Compliance PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Vice Chairman, Chief Banking Officer and Director, Fiduciary Trust Company International; and officer and/or director, as the case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 47 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------ KIMBERLEY H. MONASTERIO (39) Treasurer and Treasurer since Not Applicable None One Franklin Parkway Chief 2000 San Mateo, CA 94403-1906 Financial and Chief Officer Financial Officer since 2002 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Senior Vice President, Franklin Templeton Services, LLC; and officer of 51 of the investment companies in Franklin Templeton Investments. ------------------------------------------------------------------------------------------------------------------------------------
Annual Report | 25
------------------------------------------------------------------------------------------------------------------------------------ NUMBER OF PORTFOLIOS IN LENGTH OF FUND COMPLEX OVERSEEN NAME, AGE AND ADDRESS POSITION TIME SERVED BY BOARD MEMBER* OTHER DIRECTORSHIPS HELD ------------------------------------------------------------------------------------------------------------------------------------ MURRAY L. SIMPSON (66) Vice President Since 2000 Not Applicable None One Franklin Parkway and Secretary San Mateo, CA 94403-1906 PRINCIPAL OCCUPATION DURING PAST 5 YEARS: Executive Vice President and General Counsel, Franklin Resources, Inc.; officer and/or director, as the case may be, of some of the subsidiaries of Franklin Resources, Inc. and of 51 of the investment companies in Franklin Templeton Investments; and FORMERLY, Chief Executive Officer and Managing Director, Templeton Franklin Investment Services (Asia) Limited (until 2000); and Director, Templeton Asset Management Ltd. (until 1999). ------------------------------------------------------------------------------------------------------------------------------------
*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 adviser or affiliated investment advisers. **Charles B. Johnson and Rupert H. Johnson, Jr. are considered interested persons of the Trust under the federal securities laws due to their positions as officers and directors and major shareholders of Franklin Resources, Inc. (Resources), which is the parent company of the Trust's adviser and distributor. Harmon E. Burns is considered an interested person of the Trust under the federal securities laws due to his position as officer and director of Resources. Note: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers. THE SARBANES-OXLEY ACT OF 2002 AND RULES ADOPTED BY THE SECURITIES AND EXCHANGE COMMISSION REQUIRE THE TRUST TO DISCLOSE WHETHER THE TRUST'S AUDIT COMMITTEE INCLUDES AT LEAST ONE MEMBER WHO IS AN AUDIT COMMITTEE FINANCIAL EXPERT WITHIN THE MEANING OF SUCH ACT AND RULES. THE TRUST'S BOARD OF TRUSTEES HAVE DETERMINED THAT THERE IS AT LEAST ONE SUCH FINANCIAL EXPERT ON THE AUDIT COMMITTEE AND HAS DESIGNATED FRANK W.T. LAHAYE AS ITS AUDIT COMMITTEE FINANCIAL EXPERT. THE BOARD BELIEVES THAT MR. LAHAYE QUALIFIES AS SUCH AN EXPERT IN VIEW OF HIS EXTENSIVE BUSINESS BACKGROUND AND EXPERIENCE, INCLUDING SERVICE AS PRESIDENT AND DIRECTOR OF MCCORMICK SELPH ASSOCIATES FROM 1954 THROUGH 1965; DIRECTOR AND CHAIRMAN OF TELEDYNE CANADA LTD. FROM 1966 THROUGH 1971; DIRECTOR AND CHAIRMAN OF QUARTERDECK CORPORATION FROM 1982 THROUGH 1998; AND SERVICES AS A DIRECTOR OF VARIOUS OTHER PUBLIC COMPANIES INCLUDING U.S. TELEPHONE INC. (1981-1984), FISHER IMAGING INC. (1991-1998) AND DIGITAL TRANSMISSIONS SYSTEMS (1995-1999). IN ADDITION, MR. LAHAYE SERVED FROM 1981 TO 2000 AS A DIRECTOR AND CHAIRMAN OF PEREGRINE VENTURE MANAGEMENT CO., A VENTURE CAPITAL FIRM, AND HAS BEEN A MEMBER AND CHAIRMAN OF THE TRUST'S AUDIT COMMITTEE SINCE ITS INCEPTION. AS A RESULT OF SUCH BACKGROUND AND EXPERIENCE, THE BOARD OF TRUSTEES BELIEVES THAT MR. LAHAYE 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 TRUST, AS WELL AS AN UNDERSTANDING OF INTERNAL CONTROLS AND PROCEDURES FOR FINANCIAL REPORTING AND AN UNDERSTANDING OF AUDIT COMMITTEE FUNCTIONS. MR. LAHAYE IS AN INDEPENDENT TRUSTEE 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 1-800/DIAL BEN (1-800/342-5236) TO REQUEST THE SAI. 26 | Annual Report FRANKLIN STRATEGIC MORTGAGE PORTFOLIO PROXY VOTING POLICIES AND PROCEDURES The Fund has established Proxy Voting Policies and Procedures ("Policies") that the Fund uses to determine how to vote proxies relating to portfolio securities. Shareholders may view the Fund'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 1-954/847-2268 or by sending a written request to: Franklin Templeton Companies, LLC, 500 East Broward Boulevard, Suite 1500, Fort Lauderdale, FL 33394, Attention: Proxy Group. Annual Report | 27 This page intentionally left blank. LITERATURE REQUEST For a brochure and prospectus, which contains more complete information, including charges and expenses, call Franklin Templeton Investments at 1-800/DIAL BEN (R) (1-800/342-5236). Please read the prospectus carefully before investing or sending money. 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. FRANKLIN TEMPLETON INVESTMENTS INTERNATIONAL Mutual European Fund Templeton China World Fund Templeton Developing Markets Trust Templeton Foreign Fund Templeton Foreign Smaller Companies Fund Templeton International (Ex EM) Fund GLOBAL Franklin Global Aggressive Growth Fund Franklin Global Growth Fund Mutual Discovery Fund Templeton Capital Accumulator Fund Templeton Global Long-Short Fund Templeton Global Opportunities Trust Templeton Global Smaller Companies Fund Templeton Growth Fund Templeton World Fund GROWTH Franklin Aggressive Growth Fund Franklin Capital Growth Fund Franklin Flex Cap Growth Fund Franklin Small-Mid Cap Growth Fund Franklin Small Cap Growth Fund II 1 VALUE Franklin Balance Sheet Investment Fund 2 Franklin Equity Income Fund Franklin Large Cap Value Fund Franklin MicroCap Value Fund 3 Franklin Small Cap Value Fund Mutual Beacon Fund Mutual Qualified Fund Mutual Shares Fund BLEND Franklin Blue Chip Fund Franklin Convertible Securities Fund Franklin Growth Fund Franklin Rising Dividends Fund Franklin U.S. Long-Short Fund 4 SECTOR Franklin Biotechnology Discovery Fund Franklin DynaTech Fund Franklin Global Communications Fund Franklin Global Health Care Fund Franklin Gold and Precious Metals Fund Franklin Natural Resources Fund Franklin Real Estate Securities Fund Franklin Utilities Fund Franklin Technology Fund Mutual Financial Services Fund ASSET ALLOCATION Franklin Templeton Conservative Target Fund Franklin Templeton Growth Target Fund Franklin Templeton Moderate Target Fund Franklin Templeton Corefolio Allocation Fund Franklin Templeton Founding Funds Allocation Fund INCOME Franklin Adjustable U.S. Government Securities Fund 5 Franklin's AGE High Income Fund Franklin Federal Money Fund 5, 6 Franklin Floating Rate Daily Access Fund Franklin Floating Rate Trust 7 Franklin Income Fund Franklin Money Fund 5, 6 Franklin Short-Intermediate U.S. Government Securities Fund 5 Franklin Strategic Income Fund Franklin Strategic Mortgage Portfolio Franklin Templeton Hard Currency Fund Franklin Total Return Fund Franklin U.S. Government Securities Fund 5 Templeton Global Bond Fund TAX-FREE INCOME 8 Double Tax-Free Income Fund Federal Intermediate-Term Tax-Free Income Fund Federal Limited-Term Tax-Free Income Fund Federal Tax-Free Income Fund High Yield Tax-Free Income Fund Insured Tax-Free Income Fund 9 Tax-Exempt Money Fund 5, 6 STATE-SPECIFIC TAX-FREE INCOME 8 Alabama Arizona California 10 Colorado Connecticut Florida 10 Georgia Kentucky Louisiana Maryland Massachusetts 9 Michigan 9 Minnesota 9 Missouri New Jersey New York 10 North Carolina Ohio 9 Oregon Pennsylvania Tennessee Virginia VARIABLE INSURANCE PRODUCTS FUNDS Franklin Templeton Variable Insurance Products Trust 11 1. The fund is closed to new investors. Existing shareholders can continue adding to their accounts. 2. The fund is only open to existing shareholders as well as select retirement plans. 3. Effective June 30, 2003, the fund reopened to all new investors. 4. Upon reaching approximately $350 million in assets, the fund will close to all investors. 5. An investment in the fund is neither insured nor guaranteed by the U.S. government or by any other entity or institution. 6. No assurance exists that the fund's $1.00 per share price will be maintained. It is possible to lose money by investing in the fund. 7. 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. 8. For investors subject to the alternative minimum tax, a small portion of these dividends may be taxable. Distributions of capital gains are generally taxable. 9. Portfolio of insured municipal securities. 10. These funds are available in two or more variations, including long-term portfolios, portfolios of insured securities, a high-yield portfolio (CA) and limited-term, intermediate-term and money market portfolios (CA and NY). 11. The funds of the Franklin Templeton Variable Insurance Products Trust are generally available only through insurance company variable contracts. 09/03 Not part of the annual report [LOGO OMITTED] FRANKLIN(R) TEMPLETON(R) INVESTMENTS One Franklin Parkway San Mateo, CA 94403-1906 WANT TO RECEIVE THIS DOCUMENT FASTER VIA EMAIL? Eligible shareholders can sign up for eDelivery at franklintempleton.com. See inside for details. ANNUAL REPORT AND SHAREHOLDER LETTER Franklin Strategic Mortgage Portfolio INVESTMENT MANAGER Franklin Advisers, Inc. DISTRIBUTOR Franklin Templeton Distributors, Inc. 1-800/DIAL BEN (R) franklintempleton.com SHAREHOLDER SERVICES 1-800/632-2301 This report must be preceded or accompanied by the current Franklin Strategic Mortgage Portfolio prospectus, which contains more complete information including charges, expenses and risks. 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 A2003 11/03 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 10(a), the Registrant is attaching as an exhibit a copy of its code of ethics that applies to its principal executive officers 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 if Frank W.T. LaHaye and he is "independent" as defined under the relevant Securities and Exchange Commission Rules and Releases. Item 4. Principal Accountant Fees and Services. N/A Item 5. Audit Committee of Listed Registrants. N/A Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies. N/A Item 9. 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 10. Exhibits. (A) Code of Ethics for Principal Executive and Senior Financial Officers. (B)(1) Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Jimmy D. Gambill, Chief Executive Officer - Finance and Administration, and Kimberley H. Monasterio, Chief Financial Officer (B(2) Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Jimmy D. Gambill, Chief Executive Officer - Finance and Administration, and Kimberley H. Monasterio, Chief Financial 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/Jimmy D. Gambill Chief Executive Officer - Finance and Administration Date November 28, 2003 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/Jimmy D. Gambill Chief Executive Officer - Finance and Administration Date November 28, 2003 By /s/Kimberley H. Monasterio Chief Financial Officer Date November 28, 2003