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FranklinStrategic Mortgage Portfolio

SEPTEMBER 30, 2011

ANNUAL REPORTAND SHAREHOLDER LETTER

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F I XED INCOME

Franklin Templeton InvestmentsGain From Our Perspective®

Franklin Templeton’s distinct multi-manager structure combines thespecialized expertise of three world-class investment management groups—Franklin, Templeton and Mutual Series.

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 investingand 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, withoffices 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.

Because our management groups work independently and adhere to differentinvestment approaches, Franklin, Templeton and Mutual Series funds typicallyhave distinct portfolios. That’s why our funds can be used to build trulydiversified allocation plans covering every major asset class.

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 trustednames in financial services.

TRUE DIVERSIFICATION

RELIABILITY YOU CAN TRUST

SPECIALIZED EXPERTISE

MUTUAL FUNDS | RETIREMENT PLANS | 529 COLLEGE SAVINGS PLANS | SEPARATE ACCOUNTS

Not part of the annual report

Not part of the annual report | 1

Shareholder LetterDear Shareholder:

During the 12 months ended September 30, 2011, the U.S. economy grewmoderately. Domestic manufacturing activity generally slowed in the period’ssecond half amid high commodity prices, and economic challenges remainedincluding high unemployment, housing market weakness and a huge fiscaldebt. Inflation increased in many countries but was subdued in the U.S., andthe Federal Reserve Board maintained its accommodative monetary policy toencourage economic activity. Equity markets experienced significant volatilityin response to natural disasters, civil unrest and sovereign debt concerns in dif-ferent parts of the world. Higher quality fixed income markets generallybenefited from investor risk aversion.

Although the recent environment has been challenging, we remain cautiouslyoptimistic about the U.S. and global economies as developed countries attemptto address their fiscal problems and high debt levels while emerging economiescontinue to show growth. Keep in mind we have navigated through past peri-ods of economic uncertainty and market volatility by remaining committed toour long-term perspective and disciplined investment approach. First and fore-most for us, this means conducting rigorous, fundamental analysis of securitieswith a continual emphasis on investment risk management.

Franklin Strategic Mortgage Portfolio’s annual report goes into greater detailabout prevailing conditions during the period under review. In addition, youwill find Fund performance data, financial information and a discussion fromthe portfolio managers. Please remember all securities markets fluctuate, as domutual fund share prices.

NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE

ContentsAnnual Report

Franklin Strategic MortgagePortfolio . . . . . . . . . . . . . . . . . 3

Performance Summary . . . . . . 8

Your Fund’s Expenses . . . . . . . 10

Financial Highlights and Statement of Investments . . . 12

Financial Statements . . . . . . . 19

Notes to Financial Statements . . . . . . . 22

Report of Independent Registered Public Accounting Firm . . . . . . . . . . . 32

Tax Designation . . . . . . . . . . . 33

Board Members and Officers . . 34

Shareholder Information . . . . 39

Shareholder Letter . . . . . . . 1

If you would like more frequent updates, franklintempleton.com provides dailyprices, monthly performance figures, portfolio holdings and other information.You can also access your account, buy and sell shares, read timely articles, andfind helpful financial planning tools. We hope you will take advantage of theseonline services.

Although market conditions are constantly changing, we remain committed to our disciplined strategy as we manage the Fund. As always, we recommendinvestors 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 most people benefit from profes-sional advice and that advice is invaluable as investors navigate current marketconditions.

We thank you for investing with Franklin Templeton, welcome your questionsand comments, and look forward to serving your investment needs in theyears ahead.

Sincerely,

Christopher J. Molumphy, CFAPresident and Chief Executive Officer – Investment ManagementFranklin Strategic Mortgage Portfolio

CFA® is a trademark owned by CFA Institute.

This letter reflects our analysis and opinions as of September 30, 2011. 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 | 3

Short-Term

GNMA

Portfolio BreakdownBased on Total Investments as of 9/30/11

Federal National Mortgage Association (Fannie Mae) 42.3%Federal Home Loan Mortgage Corp. (Freddie Mac) 21.3%Asset-Backed Securities & Commercial Mortgage-Backed Securities 16.0%Government National Mortgage Association (Ginnie Mae) 1.9%Short-Term Investments 18.5%

We are pleased to bring you Franklin Strategic Mortgage Portfolio’s annualreport for the fiscal year ended September 30, 2011.

Performance Overview

For the year under review, Franklin Strategic Mortgage Portfolio – Class Adelivered a cumulative total return of +8.24%. The Fund outperformed the

Annual Report

Franklin Strategic Mortgage PortfolioYour 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 perform-

ance 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

1. Securities owned by the Fund but not shares of the Fund are guaranteed by the U.S. government, its agencies orinstrumentalities as to the timely payment of principal and interest. Although U.S. government-sponsored entities maybe 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 govern-ment agency or instrumentality securities. The Fund’s yield and share price are not guaranteed and will fluctuate withmarket conditions.

The dollar value, number of shares or principal amount, and names of all portfolio holdings are listed in the Fund’sStatement of Investments (SOI). The SOI begins on page 13.

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.comor call (800) 342-5236 for most

recent month-end performance.

4 | Annual Report

+5.66% total return of its benchmark, the Citigroup U.S. Broad Investment-Grade (USBIG) Mortgage Index, which is the mortgage component of theCitigroup USBIG Bond Index.2 For comparison, the Lipper U.S. MortgageFunds Classification Average, which consists of funds chosen by Lipper thatinvest primarily in mortgages and securities issued or guaranteed by the U.S.government and certain federal agencies,1 returned +5.22%.3 The BarclaysCapital (BC) U.S. Treasury Index, the U.S. Treasury component of the BC U.S.Government Index, posted a +5.97% total return.4 You can find the Fund’slong-term performance data in the Performance Summary beginning on page 8.

Economic and Market Overview

During the fiscal year under review, Federal Reserve Board (Fed) policymakersmaintained historically low interest rates while adopting a more restrainedview of the economy largely because of developments in Europe and signs theU.S. economic expansion lacked momentum. To promote a stronger recoveryand help maintain inflation levels the Fed believed consistent with its dual man-date to foster maximum employment and price stability, the Fed undertook asecond round of quantitative easing consisting of a $600 billion purchase oflonger term U.S. Treasuries, which ended on June 30. Subsequently, the Fedcontinued to purchase U.S. Treasuries with proceeds from maturing debt in aneffort to support economic growth.

Despite the Fed’s actions, the economy grew more slowly than expected.Housing market weakness continued and unemployment remained high. Aftershowing solid improvement through the first half of the reporting period, man-ufacturing activity weakened partly because of global supply-chain disruptionsfollowing Japan’s natural disasters. Geopolitical instability in some oil-producingregions drove up oil prices for much of the period. However, investor concernsover weak economic data caused crude oil prices to drop from their 12-monthhigh of $114 per barrel on April 29 to $79 at period-end. Storms and droughtsin several states reduced crop yields, pushing up grain prices. As oil and foodprices rose, the pace of inflation accelerated during the period.

2. Source: © 2011 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstarand/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete ortimely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use ofthis information.

3. Source: Lipper Inc. For the six-month period ended 9/30/11, this category consisted of 92 funds. Lipper calculationsdo not include sales charges or subsidization by a fund’s manager. The Fund’s performance relative to the averagemight have differed if these or other factors had been considered.

4. Source: © 2011 Morningstar. 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 withmarket conditions.

The indexes are unmanaged and include reinvestment of any income or distributions. One cannot invest directly in anindex, and an index is not representative of the Fund’s portfolio.

Annual Report | 5

Generally favorable economic improvements and positive corporate earningsreports somewhat eased investor concerns about the turmoil in North Africaand the Middle East, multiple crises triggered by Japan’s earthquake, wideningdebt problems in the eurozone and headwinds facing the U.S. economy. Duringthe 12 months under review, fixed income markets, as measured by the BC U.S.Aggregate Index, performed well and U.S. stocks, as measured by the Standard& Poor’s® 500 Index, posted small gains.5 Heightened volatility, however, roiledglobal financial markets due to U.S. lawmakers’ protracted debate and eventualcompromise on the debt limit, independent credit rating agency Standard &Poor’s downgrade of the long-term U.S. credit rating to AA+ from AAA, andfears of a sovereign debt crisis contagion in Europe. Near period-end, the Fedannounced plans intended to boost the economy by driving down long-terminterest rates. The Fed will sell $400 billion in short-term securities over thenext year, and purchase an equal amount of long-term securities. The Fed alsoanticipated it would keep short-term rates near zero through mid-2013. In thisenvironment, investors sought the perceived safe haven of U.S. Treasuries, whichdrove prices higher and yields lower for the fiscal year under review.

Investment Strategy

We invest at least 80% of the Fund’s net assets in mortgage securities. Normallywe focus on mortgage pass-through securities issued or guaranteed by theGovernment National Mortgage Association, Fannie Mae and Freddie Mac.At least 65% of total assets are invested in securities rated AAA by Standard& Poor’s, or Aaa by Moody’s Investors Service (Moody’s), independent creditrating agencies. For the remaining 35% of portfolio securities, up to 15% may be invested in securities rated below BBB by S&P, or Baa by Moody’s. Ifunrated, securities will be deemed of comparable quality by the Fund’s manager.Within these parameters, we rely on our research to help us identify attractiveinvestment opportunities.

Manager’s Discussion

The Fed initiated a program (dubbed Operation Twist by commentators)intended to further reduce longer term borrowing costs and spur refinancingand economic activity. As part of Operation Twist, the Fed will reinvest mort-gage principal and agency debenture payments into mortgage-backed securities(MBS). This program will keep the Fed’s MBS portfolio from declining, and

Dividend Distributions*10/1/10–9/30/11

Month Dividend per Share

October 3.2519 cents

November 3.5219 cents

December** 4.0343 cents

January 3.6949 cents

February 3.7125 cents

March 3.7112 cents

April 3.5014 cents

May 3.7920 cents

June 3.6255 cents

July 3.3759 cents

August 4.1122 cents

September 3.4651 cents

Total 43.7988 cents

*Assumes shares were purchased and held for theentire accrual period. Since dividends accrue daily, youractual distributions will vary depending on the date youpurchased your shares and any account activity. AllFund distributions will vary depending upon currentmarket conditions, and past distributions are notindicative of future trends.

**Includes an additional 0.66 cent per share distribu-tion to meet excise tax requirements.

5. Source: © 2011 Morningstar. STANDARD & POOR’S®, S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC. Standard & Poor’s does not sponsor, endorse, sell or promote any S&P index-basedproduct.

some analysts believe it could support the MBS sector. Prepayment riskremained heightened during the review period largely due to historically lowmortgage rates, although overall prepayment activity gradually declined. Inour view, however, a possible expansion to the Home Affordable RefinanceProgram (HARP), which covers mortgages owned or guaranteed by FannieMae or Freddie Mac, could increase the number of borrowers eligible to refi-nance their homes. Although a HARP expansion could be positive for U.S.household finances, it could negatively affect related MBS security valuations.

As measured by BC indexes, most fixed income sectors posted positive returns,but the increased volatility and uncertainty during the period led most fixedincome sectors to trail the strong performance of U.S. Treasuries. U.S. Treasuriesposted some of the best absolute performance during the period, followed by U.S.residential MBS, commercial MBS (CMBS) and asset-backed securities (ABS).

The Fund used a broad mortgage strategy that looked across all mortgageopportunity sets to find relative value, and our investment process and strategydid not change. The management team continued to look for strong cash flowfundamentals and valuations to uncover opportunities across the mortgageinvestment universe.

Although prepayment risk remained heightened, actual prepayment levels wereconstrained and generally slowed due to the associated cost of refinancing, lossof home equity, tighter underwriting standards and declining home prices. Inthis environment, we increased the Fund’s exposure to lower coupon MBS(4.0% and 4.5%). Our heaviest allocation was in 4.5% and 5.0% coupons atperiod-end.

We modestly decreased exposure to the ABS sector. We swapped out of super-senior securities, which delivered strong performance and price appreciation.Within securitized sectors, our emphasis remained on higher quality securitiesthat had higher seniority in the capital structure and benefited from strong levelsof credit protection. We remained allocated to CMBS, and credit fundamentalsshowed some signs of stabilization. We believe, however, the commercial realestate environment could remain challenged over the intermediate term. Themajority of the Fund’s CMBS allocations was high in the capital structure andgenerally benefited from high levels of credit protection, which could helpthem weather negative real estate environments. The Fund’s CMBS exposurewas a significant contributor to performance over the period. Our sector allo-cation to MBS and non-agency residential MBS also aided performance. TheFund’s yield curve positioning detracted from returns after interest rate move-ments negatively impacted performance.

6 | Annual Report

Thank you for your continued participation in Franklin Strategic MortgagePortfolio. We look forward to serving your future investment needs.

Roger A. Bayston, CFA

Paul Varunok

Portfolio Management TeamFranklin Strategic Mortgage Portfolio

The foregoing information reflects our analysis, opinions and portfolio holdings as of September 30, 2011, the endof the reporting period. The way we implement our main investment strategies and the resulting portfolio holdingsmay change depending on factors such as market and economic conditions. These opinions may not be relied uponas investment advice or an offer for a particular security. The information is not a complete analysis of everyaspect of any market, country, industry, security or the Fund. Statements of fact are from sources consideredreliable, 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 ourinvestment management philosophy.

Annual Report | 7

8 | Annual Report

Performance Summary as of 9/30/11

Price and Distribution Information

Class A (Symbol: FSMIX) Change 9/30/11 9/30/10

Net Asset Value (NAV) +$0.30 $9.39 $9.09

Distributions (10/1/10–9/30/11)

Dividend Income $0.437988

Your dividend income will vary depending on dividends or interest paid by securities in the Fund’sportfolio, adjusted for operating expenses. Capital gain distributions are net profits realized fromthe sale of portfolio securities. The performance table and graph do not reflect any taxes that ashareholder would pay on Fund dividends, capital gain distributions, if any, or any realized gainson the sale of Fund shares. Total return reflects reinvestment of the Fund’s dividends and capitalgain distributions, if any, and any unrealized gains or losses.

Performance1

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 Return2 +8.24% +28.67% +59.57%

Average Annual Total Return3 +3.68% +4.25% +4.33%

Distribution Rate4 4.30%

30-Day Standardized Yield5 2.42%

Total Annual Operating Expenses6 0.72%

Performance data represent past performance, which does not guarantee future results. Investment return and principalvalue 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, go to franklintempleton.com or call (800) 342-5236.

Performance Summary (continued)

Annual Report | 9

Total Return Index Comparison for a Hypothetical $10,000 Investment1

Total return represents the change in value of an investment over the periods shown. It includes theapplicable maximum sales charge, Fund expenses, account fees and reinvested distributions. Theunmanaged index includes reinvestment of any income or distributions. It differs from the Fund incomposition and does not pay management fees or expenses. One cannot invest directly in an index.

Average Annual Total Return

Class A 9/30/11

1-Year +3.68%

5-Year +4.25%

10-Year +4.33%

Class A (10/1/01–9/30/11)

$17,355

$15,273

Franklin Strategic Mortgage Portfolio Citigroup USBIG Mortgage Index7

9/119/099/079/059/0310/01$5,000

$10,000

$15,000

$20,000

Endnotes

The Fund’s share price and yield will be affected by interest rate movements and mortgage prepayments.During periods of declining interest rates, principal prepayments tend to increase as borrowers refinancetheir mortgages at lower rates; therefore the Fund may be forced to reinvest returned principal at lowerinterest rates, reducing income. 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. Changesin the financial strength of a bond issuer or in a bond’s credit rating may affect its value. The Fund is activelymanaged but there is no guarantee that the manager’s investment decisions will produce the desired results.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 takenthis 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 periodsindicated.

4. Distribution rate is based on an annualization of the sum of distributions per share for the 30 days of Septemberand the maximum offering price of $9.81 on 9/30/11.

5. The 30-day standardized yield for the 30 days ended 9/30/11 reflects an estimated yield to maturity (assumingall portfolio securities are held to maturity). It should be regarded as an estimate of the Fund’s rate of investmentincome, and it may not equal the Fund’s actual income distribution rate (which reflects the Fund’s past dividendspaid 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 figuresshown.

7. Source: © 2011 Morningstar. The Citigroup USBIG Mortgage Index is the mortgage component of the CitigroupUSBIG Bond Index and comprises 30- and 15-year GNMA, FNMA and FHLMC securities and FNMA and FHLMC balloon mortgages.

Your Fund’s Expenses

10 | Annual Report

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 otherFund 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 understandthese costs and compare them with those of other mutual funds. The table assumes a $1,000investment 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 andexpenses. The “Ending Account Value” is derived from the Fund’s actual return, which includesthe 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 compareongoing 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 andan assumed 5% annual rate of return before expenses, which does not represent the Fund’s actualreturn. The figure under the heading “Expenses Paid During Period” shows the hypotheticalexpenses your account would have incurred under this scenario. You can compare this figure withthe 5% hypothetical examples that appear in shareholder reports of other funds.

Your Fund’s Expenses (continued)

Annual Report | 11

Please note that expenses shown in the table are meant to highlight ongoing costs and do not reflectany transaction costs, such as sales charges. Therefore, the second line for each class is useful incomparing 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 referto the Fund prospectus for additional information on operating expenses.

Beginning Account Ending Account Expenses Paid During Class A Value 4/1/11 Value 9/30/11 Period* 4/1/11–9/30/11

Actual $1,000 $1,028.90 $3.20

Hypothetical (5% return before expenses) $1,000 $1,021.91 $3.19

*Expenses are calculated using the most recent six-month annualized expense ratio of 0.63%, multiplied by the average account value over theperiod, multiplied by 183/365 to reflect the one-half year period.

Franklin Strategic Mortgage PortfolioFinancial Highlights

12 | The accompanying notes are an integral part of these financial statements. | Annual Report

Year Ended September 30,2011 2010 2009 2008 2007

Per share operating performance(for a share outstanding throughout the year)

Net asset value, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . $9.09 $8.75 $8.80 $9.42 $9.59

Income from investment operationsa:

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.269 0.333 0.306 0.404 0.476

Net realized and unrealized gains (losses) . . . . . . . . . . . . . . . . . . . 0.469 0.487 0.163 (0.493) (0.129)

Total from investment operations . . . . . . . . . . . . . . . . . . . . . . . . . . 0.738 0.820 0.469 (0.089) 0.347

Less distributions from net investment income . . . . . . . . . . . . . . . . . (0.438) (0.480) (0.519) (0.531) (0.517)

Redemption feesb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — — — —c —c

Net asset value, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.39 $9.09 $8.75 $8.80 $9.42

Total returnd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.24% 9.61% 5.69% (1.04)% 3.70%

Ratios to average net assets

Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.65% 0.70% 0.67%e 0.57%e 0.57%e

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.85% 3.76% 4.16% 4.58% 5.05%

Supplemental data

Net assets, end of year (000’s) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,529 $100,549 $101,961 $168,674 $243,664

Portfolio turnover rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539.76% 341.45% 273.38% 336.36% 326.67%

Portfolio turnover rate excluding mortgage dollar rollsf . . . . . . . . . . . 126.63% 20.82% 9.39% 25.39% 30.85%

aThe 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 ofthe Fund shares in relation to income earned and/or fluctuating market value of the investments of the Fund.bEffective September 1, 2008, the redemption fee was eliminated.cAmount rounds to less than $0.001 per share.dTotal return does not reflect sales commissions or contingent deferred sales charges, if applicable.eBenefit of expense reduction rounds to less than 0.01%.fSee Note 1(f) regarding mortgage dollar rolls.

Principal Amount* Value

Asset-Backed Securities and Commercial Mortgage-Backed Securities 23.5%

Franklin Strategic Mortgage PortfolioStatement of Investments, September 30, 2011

Annual Report | 13

Finance 23.5%aAFC Home Equity Loan Trust, 1997-4, 2A2, 0.875%, 12/22/27 . . . . . . . . . . . . . . . . . . . . . . 265,235 $ 211,309aAmeriquest Mortgage Securities Inc., 2003-12, M2, 2.785%, 1/25/34 . . . . . . . . . . . . . . . . . 760,684 386,530Banc of America Commercial Mortgage Inc.,

2006-1, AJ, 5.46%, 9/10/45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 813,1322006-1, AM, 5.421%, 9/10/45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 1,105,6092006-4, AJ, 5.695%, 7/10/46 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 190,4272006-4, AM, 5.675%, 7/10/46 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 280,937

a,bBanc of America Large Loan, 2010-HLTN, 144A, 1.979%, 11/15/15 . . . . . . . . . . . . . . . . . . . 1,159,438 1,035,100a,bBayview Commercial Asset Trust, 2006-CD1A, A-1, 144A, 1.489%, 7/25/23 (Canada) . . . . . . 418,870 CAD 393,692

aBear Stearns Alt-A Trust, 2004-13, A2, 1.115%, 11/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . . 419,091 294,705Bear Stearns Commercial Mortgage Securities Inc.,a,b2006-PW11, D, 144A, 5.452%, 3/11/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 246,275

2006-PW13, AJ, 5.611%, 9/11/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000 587,017CitiFinancial Mortgage Securities Inc., 2003-4, AF6, 4.493%, 10/25/33 . . . . . . . . . . . . . . . . 1,237,583 1,194,100

aCitigroup Commercial Mortgage Trust, 2007-C6, AM, 5.697%, 6/10/17 . . . . . . . . . . . . . . . . . 500,000 458,196aCitigroup/Deutsche Bank Commercial Mortgage Trust,

2005-CD1, AJ, 5.226%, 7/15/44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 399,3882006-CD3, AJ, 5.688%, 10/15/48 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 238,646

Commercial Mortgage Pass-through Certificate, 2005-C6, AJ, 5.209%, 6/10/44 . . . . . . . . . . . 500,000 435,747Countrywide Home Loans, 2004-J8, 3A3, 5.50%, 12/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . 56,812 57,415

a,bCredit Suisse Mortgage Capital Certificates, 2006-TF2A, A2, 144A, 0.399%, 10/15/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226,796 209,970

aFirst Franklin Mortgage Loan Asset-Backed Certificates, 2004-FF11, 1A2, 0.585%, 1/25/35 . . . 280,716 265,885FNMA,

a2007-1, NF, 0.485%, 2/25/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588,590 585,943G93-33, K, 7.00%, 9/25/23 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,146,481 1,303,335

GMAC Commercial Mortgage Securities Inc., 2005-C1, B, 4.936%, 5/10/43 . . . . . . . . . . . . . 800,000 603,673aGS Mortgage Securities Corp. II, 2007-GG10, A4, 5.79%, 8/10/45 . . . . . . . . . . . . . . . . . . . . 1,000,000 1,043,220aHome Equity Mortgage Trust, 2004-4, M3, 1.21%, 12/25/34 . . . . . . . . . . . . . . . . . . . . . . . . 623,352 451,138aHomebanc Mortgage Trust, 2005-4, A1, 0.505%, 10/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . 213,444 141,041aJPMorgan Chase Commercial Mortgage Securities Corp., 2006-CB14,

AM, 5.542%, 12/12/44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 936,914B, 5.452%, 12/12/44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 485,523

LB-UBS Commercial Mortgage Trust, 2006-C6, AJ, 5.452%, 9/15/39 . . . . . . . . . . . . . . . . . . 500,000 389,045Lehman ABS Corp., 2003-1, A1, 5.00%, 12/25/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,340,108 1,376,065

aMerrill Lynch Mortgage Investors Inc., 2003-A, 1A, 0.975%, 3/25/28 . . . . . . . . . . . . . . . . . . 716,593 619,355aMorgan Stanley ABS Capital I Inc. Trust,

2003-HE1, M1, 1.435%, 5/25/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 669,338 544,4392005-WMC, M2, 0.97%, 1/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 396,814

aMorgan Stanley Capital I Trust, 2004-IQ7, A4, 5.48%, 6/15/38 . . . . . . . . . . . . . . . . . . . . . . . 2,050,000 2,197,577aNovastar Home Equity Loan, 2004-4, M4, 1.885%, 3/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 1,127,572Residential Asset Securities Corp.,

2004-KS1, AI4, 4.213%, 4/25/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356,027 347,733a2005-AHL2, A2, 0.495%, 10/25/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,825 65,212

a,bStructured Asset Securities Corp., 2005-SC1, 1A1, 144A, 0.505%, 5/25/31 . . . . . . . . . . . . . 605,193 270,408aTravelers Mortgage Services Inc., 1998-5A, A, 2.469%, 12/25/18 . . . . . . . . . . . . . . . . . . . . . 70,478 70,018

Franklin Strategic Mortgage PortfolioStatement of Investments, September 30, 2011 (continued)

14 | Annual Report


Asset-Backed Securities and Commercial Mortgage-Backed Securities (continued)Finance (continued)Wachovia Bank Commercial Mortgage Trust,

5.738%, 5/15/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 $ 709,865a2006-C25, AJ, 5.737%, 5/15/43 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 249,9932006-C28, AJ, 5.632%, 10/15/48 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 321,972

a,b2007-WHL8, A1, 144A, 0.309%, 6/15/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309,074 271,314Wells Fargo Mortgage Backed Securities Trust,

a2004-W, A9, 2.620%, 11/25/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412,935 384,0802007-3, 3A1, 5.50%, 4/25/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,411 455,154

Total Asset-Backed Securities and Commercial Mortgage-Backed Securities (Cost $25,893,540) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,151,483

Mortgage-Backed Securities 96.4%aFederal Home Loan Mortgage Corp. (FHLMC) Adjustable Rate 7.9%FHLMC, 2.00%, 4/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,068 29,698FHLMC, 2.05%, 11/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154,504 156,123FHLMC, 2.175%, 5/01/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,510 115,972FHLMC, 2.202%, 11/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,420 67,863FHLMC, 2.33%, 7/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,180 737,713FHLMC, 2.418%, 5/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,688 53,478FHLMC, 2.445%, 3/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,252 136,582FHLMC, 2.48%, 1/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,437 48,613FHLMC, 2.50%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,355 53,436FHLMC, 2.545%, 1/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,863 144,938FHLMC, 2.658%, 8/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,982 29,420FHLMC, 2.696%, 12/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,068 84,829FHLMC, 2.886%, 7/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,953 43,132FHLMC, 2.897%, 4/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,667 63,185FHLMC, 3.186%, 4/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,057 116,168FHLMC, 3.966%, 10/01/36 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833,041 881,514FHLMC, 4.583%, 1/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219,836 232,403FHLMC, 4.675%, 11/01/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,704,856 3,895,593FHLMC, 5.023%, 7/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312,196 315,123FHLMC, 5.025%, 4/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627,477 662,866FHLMC, 5.893%, 10/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,535 103,016FHLMC, 6.876%, 11/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,995 105,802

8,077,467

Federal Home Loan Mortgage Corp. (FHLMC) Fixed Rate 23.4%FHLMC Gold 15 Year, 8.00%, 12/01/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 765 769

cFHLMC Gold 30 Year, 4.00%, 10/01/41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,900,000 3,034,578cFHLMC Gold 30 Year, 4.50%, 10/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,900,000 12,589,828FHLMC Gold 30 Year, 5.00%, 10/01/33 - 7/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645,663 696,645

cFHLMC Gold 30 Year, 5.00%, 10/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000 1,286,813FHLMC Gold 30 Year, 5.50%, 9/01/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218,955 238,606FHLMC Gold 30 Year, 6.00%, 7/01/28 - 12/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,429 27,088

cFHLMC Gold 30 Year, 6.00%, 10/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000 3,286,876


Annual Report | 15


Mortgage-Backed Securities (continued)Federal Home Loan Mortgage Corp. (FHLMC) Fixed Rate (continued)FHLMC Gold 30 Year, 6.50%, 2/01/19 - 7/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 570,649 $ 641,708FHLMC Gold 30 Year, 7.50%, 10/01/25 - 8/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492,401 575,907FHLMC Gold 30 Year, 8.00%, 7/01/24 - 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142,122 166,542FHLMC Gold 30 Year, 8.50%, 10/01/17 - 9/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169,095 194,869FHLMC Gold 30 Year, 9.00%, 9/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99,824 122,014FHLMC Gold 30 Year, 9.50%, 12/01/16 - 4/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515,975 597,905FHLMC PC 30 Year, 8.50%, 2/01/17 - 5/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470,778 520,105FHLMC PC 30 Year, 9.00%, 6/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 856 963FHLMC PC 30 Year, 9.25%, 8/01/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,635 2,843FHLMC PC 30 Year, 9.50%, 8/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,204 52,501

24,036,560

aFederal National Mortgage Association (FNMA) Adjustable Rate 12.3%FNMA, 1.788%, 4/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,679 45,131FNMA, 2.075%, 4/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,095 10,325FNMA, 2.226%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,336 20,922FNMA, 2.25%, 11/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,151 125,041FNMA, 2.275%, 7/01/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,856 102,798FNMA, 2.337%, 11/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269,806 283,409FNMA, 2.36%, 12/01/22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,921 75,746FNMA, 2.365%, 2/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,806 100,945FNMA, 2.374%, 7/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716,664 757,326FNMA, 2.375%, 9/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,846 37,945FNMA, 2.395%, 7/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,880 125,846FNMA, 2.402%, 12/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,127 51,280FNMA, 2.421%, 4/01/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,590 124,487FNMA, 2.441%, 8/01/29 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,750 37,558FNMA, 2.445%, 5/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,890 105,883FNMA, 2.45%, 8/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,376 142,189FNMA, 2.476%, 7/01/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,140 52,137FNMA, 2.50%, 9/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331,774 351,265FNMA, 2.525%, 6/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342,996 345,068FNMA, 2.541%, 10/01/36 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,598,981 1,690,623FNMA, 2.583%, 4/01/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,567 97,330FNMA, 2.588%, 1/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,241,761 1,274,737FNMA, 2.59%, 5/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,310 25,493FNMA, 2.591%, 10/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,580 265,523FNMA, 2.71%, 10/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,121 179,066FNMA, 2.77%, 7/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,407 38,891FNMA, 2.87%, 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71,493 75,393FNMA, 3.198%, 1/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,229 438,524FNMA, 3.395%, 8/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,895 112,863FNMA, 3.645%, 10/01/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,929 173,677FNMA, 3.845%, 5/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183,445 193,199FNMA, 3.972%, 12/01/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,234 67,661FNMA, 4.356%, 7/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,774 57,855FNMA, 4.413%, 7/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424,623 449,522


16 | Annual Report


Mortgage-Backed Securities (continued)aFederal National Mortgage Association (FNMA) Adjustable Rate (continued)FNMA, 4.603%, 9/01/37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,184,903 $ 4,394,324FNMA, 4.614%, 4/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129,820 136,967FNMA, 4.931%, 6/01/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,164 63,433

12,630,382

Federal National Mortgage Association (FNMA) Fixed Rate 49.9%FNMA 15 Year, 5.00%, 6/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429,803 465,102FNMA 15 Year, 5.00%, 7/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,439,269 1,557,473FNMA 15 Year, 5.50%, 5/01/14 - 2/01/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,280,627 1,387,174FNMA 15 Year, 6.50%, 5/01/14 - 10/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92,867 101,760FNMA 15 Year, 7.50%, 7/01/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,655 2,669

cFNMA 30 Year, 4.00%, 10/01/40 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,500,000 8,911,719cFNMA 30 Year, 4.50%, 10/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,015,000 16,993,416FNMA 30 Year, 5.00%, 4/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 697,889 758,802FNMA 30 Year, 5.50%, 11/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,313,968 2,528,155FNMA 30 Year, 5.50%, 9/01/33 - 11/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,539,167 4,967,632FNMA 30 Year, 6.00%, 10/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,515,981 2,799,579FNMA 30 Year, 6.00%, 10/01/34 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 952,364 1,062,392FNMA 30 Year, 6.00%, 12/01/23 - 8/01/35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,670,832 1,864,838

cFNMA 30 Year, 6.00%, 10/01/39 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,800,000 3,071,688FNMA 30 Year, 6.50%, 12/01/27 - 8/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,158,834 3,562,680FNMA 30 Year, 7.50%, 8/01/25 - 5/01/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,238 112,794FNMA 30 Year, 8.00%, 1/01/25 - 7/01/31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,487 69,889FNMA 30 Year, 8.50%, 11/01/26 - 11/01/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484,240 567,212FNMA 30 Year, 9.00%, 12/01/16 - 9/01/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,995 46,262FNMA 30 Year, 9.50%, 11/01/15 - 4/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123,597 146,244FNMA 30 Year, 10.00%, 7/01/16 - 4/01/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,811 116,347FNMA 30 Year, 10.50%, 4/01/22 - 5/01/30 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,157 12,229FNMA 30 Year, 12.00%, 4/01/15 - 5/01/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,496 1,543FNMA 30 Year, 12.50%, 12/01/13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 234FNMA GL 30 Year, 10.00%, 8/01/15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,690 16,052FNMA PL 30 Year, 10.00%, 9/01/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,747 23,252

51,147,137

aGovernment National Mortgage Association (GNMA) Adjustable Rate 0.2%GNMA, 1.625%, 7/20/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,269 135,278GNMA, 2.125%, 11/20/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,657 55,631

190,909

Government National Mortgage Association (GNMA) Fixed Rate 2.7%GNMA I SF 15 Year, 7.00%, 4/15/14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,741 6,123GNMA I SF 15 Year, 8.00%, 9/15/15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,727 18,030GNMA I SF 30 Year, 6.50%, 1/15/24 - 9/15/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432,796 500,236GNMA I SF 30 Year, 7.00%, 5/15/17 - 2/15/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322,801 366,687GNMA I SF 30 Year, 7.50%, 10/15/23 - 10/15/29 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,278 77,235GNMA I SF 30 Year, 8.00%, 1/15/17 - 9/15/27 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192,991 220,871


Annual Report | 17


Mortgage-Backed Securities (continued)Government National Mortgage Association (GNMA) Fixed Rate (continued)GNMA I SF 30 Year, 8.25%, 1/15/21 - 5/15/21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,187 $ 139,759GNMA I SF 30 Year, 8.50%, 6/15/16 - 7/15/24 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212,315 233,029GNMA I SF 30 Year, 9.00%, 9/15/16 - 8/15/28 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,232 31,050GNMA I SF 30 Year, 10.00%, 12/15/18 - 2/15/19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,965 6,016GNMA I SF 30 Year, 10.50%, 1/15/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676 682GNMA II SF 30 Year, 6.50%, 1/20/26 - 1/20/33 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505,494 580,719GNMA II SF 30 Year, 7.50%, 11/20/22 - 7/20/32 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331,433 386,068GNMA II SF 30 Year, 8.00%, 1/20/17 - 8/20/26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99,017 108,726GNMA II SF 30 Year, 8.50%, 7/20/16 - 8/20/16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,242 50,978GNMA II SF 30 Year, 9.00%, 11/20/19 - 3/20/25 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,336 5,150GNMA II SF 30 Year, 10.50%, 6/20/20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 23

2,731,382

Total Mortgage-Backed Securities (Cost $96,453,149) . . . . . . . . . . . . . . . . . . . . 98,813,837

Total Investments before Short Term Investments (Cost $122,346,689) . . . . . . 122,965,320

Shares

Short Term Investments 27.1%Money Market Funds (Cost $5,088,632) 5.0%

d,eInstitutional Fiduciary Trust Money Market Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,088,632 5,088,632

Principal Amount

Repurchase Agreements (Cost $22,713,800) 22.1%f Joint Repurchase Agreement, 0.029%, 10/03/11 (Maturity Value $22,713,855) . . . . . . . . . . $22,713,800 22,713,800

Barclays Capital Inc. (Maturity Value $2,190,524)BNP Paribas Securities Corp. (Maturity Value $2,738,155)Credit Suisse Securities (USA) LLC (Maturity Value $5,020,443)Deutsche Bank Securities Inc. (Maturity Value $4,550,267)HSBC Securities (USA) Inc. (Maturity Value $2,738,155)Merrill Lynch, Pierce, Fenner & Smith Inc. (Maturity Value $2,738,155)Morgan Stanley & Co. LLC (Maturity Value $912,643)UBS Securities LLC (Maturity Value $1,825,513)Collateralized by U.S. Government Agency Securities, 0.00% - 5.25%, 12/07/11 - 5/04/37;

gU.S. Treasury Bills, 12/15/11 - 9/20/12; U.S. Treasury Bonds, 9.25%, 2/15/16; and U.S. Treasury Notes, 0.375% - 4.25%, 1/15/12 - 7/31/16 (valued at $23,254,110)

Total Investments (Cost $150,149,121) 147.0% . . . . . . . . . . . . . . . . . . . . . . . . . . 150,767,752

Other Assets, less Liabilities (47.0)% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (48,238,446)

Net Assets 100.0% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,529,306



*The principal amount is stated in U.S. dollars unless otherwise indicated.aThe coupon rate shown represents the rate at period end.bSecurity 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 ina public offering registered under the Securities Act of 1933. These securities have been deemed liquid under guidelines approved by the Fund’s Board of Trustees. At September 30,2011, the aggregate value of these securities was $2,426,759, representing 2.37% of net assets.cSecurity purchased on a to-be-announced (TBA) basis. See Note 1(d).dNon-income producing.eSee Note 7 regarding investments in the Institutional Fiduciary Trust Money Market Portfolio.fSee Note 1(c) regarding joint repurchase agreement.gThe security is traded on a discount basis with no stated coupon rate.

At September 30, 2011, the Fund had the following financial futures contracts outstanding. See Note 1(e).

Number of Notional Expiration Unrealized UnrealizedDescription Type Contracts Value Date Appreciation Depreciation

U.S. Long Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . Short 3 $427,875 12/20/11 $ — $(1,508)

See Abbreviations on page 31.

Franklin Strategic Mortgage PortfolioFinancial Statements

Annual Report | The accompanying notes are an integral part of these financial statements. | 19

Statement of Assets and LiabilitiesSeptember 30, 2011

Assets:Investments in securities:

Cost - Unaffiliated issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,346,689Cost - Sweep Money Fund (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,088,632Cost - Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,713,800

Total cost of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,149,121

Value - Unaffiliated issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $122,965,320Value - Sweep Money Fund (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,088,632Value - Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,713,800

Total value of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,767,752Receivables:

Investment securities sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,485,936Capital shares sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624,633Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306,165Due from brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,253Variation margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,282,239

Liabilities:Payables:

Investment securities purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,252,970Capital shares redeemed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339,237Affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,113Distributions to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,236

Accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,377

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,752,933

Net assets, at value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,529,306

Net assets consist of:Paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $139,293,098Undistributed net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,495Net unrealized appreciation (depreciation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 617,123Accumulated net realized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (37,383,410)

Net assets, at value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,529,306

Shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,923,502

Net asset value per sharea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.39

Maximum offering price per share (net asset value per share ÷ 95.75%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9.81

aRedemption price is equal to net asset value less contingent deferred sales charges, if applicable.

Franklin Strategic Mortgage PortfolioFinancial Statements (continued)


Statement of Operationsfor the year ended September 30, 2011

Investment income:Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,500,380

Expenses:Management fees (Note 3a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 392,284Transfer agent fees (Note 3d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,958Custodian fees (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,279Reports to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,098Registration and filing fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,145Professional fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,715Trustees’ fees and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,470Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,211

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 650,160

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,850,220

Realized and unrealized gains (losses):Net realized gain (loss) from:

Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,020,620)Foreign currency transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 766,955

Net realized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,253,481)

Net change in unrealized appreciation (depreciation) on:Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,245,017Translation of other assets and liabilities denominated in foreign currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

Net change in unrealized appreciation (depreciation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,245,179

Net realized and unrealized gain (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,991,698

Net increase (decrease) in net assets resulting from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,841,918

Franklin Strategic Mortgage PortfolioFinancial Statements (continued)

Annual Report | The accompanying notes are an integral part of these financial statements. | 21

Statements of Changes in Net Assets

Year Ended September 30,2011 2010

Increase (decrease) in net assets:Operations:

Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,850,220 $ 3,791,640Net realized gain (loss) from investments, foreign currency transactions and futures contracts . . . (3,253,481) (1,057,939)Net change in unrealized appreciation (depreciation) on investments and translation of other assets and liabilities denominated in foreign currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,245,179 6,527,702

Net increase (decrease) in net assets resulting from operations . . . . . . . . . . . . . . . . . . . . . 7,841,918 9,261,403Distributions to shareholders from net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,691,899) (5,422,467)Capital share transactions (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,169,755) (5,250,752)

Net increase (decrease) in net assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,980,264 (1,411,816)Net assets:

Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,549,042 101,960,858

End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $102,529,306 $100,549,042

Undistributed net investment income (distributions in excess of net investment income) included in net assets:End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,495 $ (4,275)

Franklin Strategic Mortgage PortfolioNotes to Financial Statements

22 | Annual Report

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. Financial Instrument Valuation

The Fund’s investments in securities and other financial instruments are carried at fair value daily.Fair value is the price that would be received to sell an asset or paid to transfer a liability in anorderly transaction between market participants on the measurement date. Under proceduresapproved by the Fund’s Board of Trustees, the Fund may utilize independent pricing services,quotations from securities and financial instrument dealers, and other market sources to deter-mine fair value.

Debt securities generally trade in the over-the-counter market rather than on a securities exchange.The Fund’s pricing services use multiple valuation techniques to determine fair value. In instanceswhere sufficient market activity exists, the pricing services may utilize a market-based approachthrough which quotes from market makers are used to determine fair value. In instances wheresufficient market activity may not exist or is limited, the pricing services also utilize proprietaryvaluation models which may consider market characteristics such as benchmark yield curves,option-adjusted spreads, credit spreads, estimated default rates, coupon rates, anticipated timingof principal repayments, underlying collateral, and other unique security features in order toestimate the relevant cash flows, which are then discounted to calculate the fair value. Securitiesdenominated in a foreign currency are converted into their U.S. dollar equivalent at the foreignexchange rate in effect at the close of the NYSE on the date that the values of the foreign debtsecurities are determined. Derivative financial instruments (derivatives) listed on an exchange arevalued at the official closing price of the day. Investments in open-end mutual funds are valuedat the closing net asset value. Repurchase agreements are valued at cost, which approximatesmarket value.

The Fund has procedures to determine the fair value of securities and other financial instrumentsfor which market prices are not readily available or which may not be reliably priced. Underthese procedures, the Fund primarily employs a market-based approach which may use relatedor comparable assets or liabilities, recent transactions, market multiples, book values, and otherrelevant information for the investment to determine the fair value of the investment. The Fundmay also use an income-based valuation approach in which the anticipated future cash flows ofthe investment are discounted to calculate fair value. Discounts may also be applied due to thenature or duration of any restrictions on the disposition of the investments. Due to the inherentuncertainty of valuations of such investments, the fair values may differ significantly from thevalues that would have been used had an active market existed.

Franklin Strategic Mortgage PortfolioNotes to Financial Statements (continued)

Annual Report | 23

1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (continued)

b. Foreign Currency Translation

Portfolio securities and other assets and liabilities denominated in foreign currencies are trans-lated into U.S. dollars based on the exchange rate of such currencies against U.S. dollars on thedate of valuation. The Fund may enter into foreign currency exchange contracts to facilitatetransactions denominated in a foreign currency. Purchases and sales of securities, income andexpense items denominated in foreign currencies are translated into U.S. dollars at the exchangerate in effect on the transaction date. Portfolio securities and assets and liabilities denominatedin foreign currencies contain risks that those currencies will decline in value relative to the U.S.dollar. Occasionally, events may impact the availability or reliability of foreign exchange ratesused to convert the U.S. dollar equivalent value. If such an event occurs, the foreign exchangerate will be valued at fair value using procedures established and approved by the Fund’s Boardof Trustees.

The Fund does not separately report the effect of changes in foreign exchange rates from changesin market prices on securities held. Such changes are included in net realized and unrealized gainor loss from investments on the Statement of Operations.

Realized foreign exchange gains or losses arise from sales of foreign currencies, currency gainsor losses realized between the trade and settlement dates on securities transactions and the dif-ference between the recorded amounts of dividends, interest, and foreign withholding taxes andthe U.S. dollar equivalent of the amounts actually received or paid. Net unrealized foreignexchange gains and losses arise from changes in foreign exchange rates on foreign denominatedassets and liabilities other than investments in securities held at the end of the reporting period.

c. Joint Repurchase Agreement

The Fund enters into a joint repurchase agreement whereby its uninvested cash balance isdeposited into a joint cash account with other funds managed by the investment manager or anaffiliate 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 basedon their pro-rata interest. A repurchase agreement is accounted for as a loan by the fund to theseller, 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 thedollar amount invested by the funds, with the value of the underlying securities marked to marketdaily to maintain coverage of at least 100%. The joint repurchase agreement held by the Fundat year end had been entered into on September 30, 2011.

d. Securities Purchased on a TBA Basis

The Fund purchases securities on a to-be-announced (TBA) basis, with payment and deliveryscheduled for a future date. These transactions are subject to market fluctuations and are subjectto the risk that the value at delivery may be more or less than the trade date purchase price.


24 | Annual Report


d. Securities Purchased on a TBA Basis (continued)

Although the Fund will generally purchase these securities with the intention of holding the secu-rities, it may sell the securities before the settlement date. Sufficient assets have been segregatedfor these securities.

e. Derivative Financial Instruments

The Fund invested in derivatives in order to manage risk or gain exposure to various other invest-ments 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 berequired to have a similar response to changes in market factors, and require or permit net settle-ment. Derivatives contain various risks including the potential inability of the counterparty tofulfill their obligations under the terms of the contract, the potential for an illiquid secondarymarket, and/or the potential for market movements which expose the Fund to gains or losses inexcess of the amounts shown on the Statement of Assets and Liabilities. Realized gain and lossand unrealized appreciation and depreciation on these contracts for the period are included inthe Statement of Operations.

The Fund entered into financial futures contracts primarily to manage interest rate risk. A futurescontract is an agreement between the Fund and a counterparty to buy or sell an asset for a speci-fied price on a future date. Required initial margin deposits of cash or securities are pledged bythe 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 isaccounted for as unrealized appreciation or depreciation until the contract is closed, at whichtime the gains or losses are realized.

See Note 9 regarding other derivative information.

f. Mortgage Dollar Rolls

The Fund enters into mortgage dollar rolls, typically on a TBA basis. Mortgage dollar rolls areagreements between the Fund and a financial institution to simultaneously sell and repurchasemortgage-backed securities at a future date. Gains or losses are realized on the initial sale, andthe difference between the repurchase price and the sale price is recorded as an unrealized gainor loss to the fund upon entering into the mortgage dollar roll. In addition, the Fund may investthe cash proceeds that are received from the initial sale. During the period between the sale andrepurchase, the Fund is not entitled to principal and interest paid on the mortgage backed secu-rities. The risks of mortgage dollar roll transactions include the potential inability of thecounterparty to fulfill its obligations.


Annual Report | 25


g. Income Taxes

It is the Fund’s policy to qualify as a regulated investment company under the Internal RevenueCode. The Fund intends to distribute to shareholders substantially all of its taxable income andnet realized gains to relieve it from federal income and excise taxes. As a result, no provision forU.S. federal income taxes is required. The Fund files U.S. income tax returns as well as tax returnsin certain other jurisdictions. The Fund records a provision for taxes in its financial statementsincluding penalties and interest, if any, for a tax position taken on a tax return (or expected tobe taken) when it fails to meet the more likely than not (a greater than 50% probability) thresh-old and based on the technical merits, the tax position may not be sustained upon examinationby the tax authorities. As of September 30, 2011, and for all open tax years, the Fund has deter-mined that no provision for income tax is required in the Fund’s financial statements. Open taxyears are those that remain subject to examination and are based on each tax jurisdiction statuteof limitation.

The Fund may be subject to foreign taxation related to income received, capital gains on the sale of securities and certain foreign currency transactions in the foreign jurisdictions in which it invests. Foreign taxes, if any, are recorded based on the tax regulations and rates that exist inthe foreign markets in which the Fund invests. When a capital gain tax is determined to applythe Fund records an estimated deferred tax liability for unrealized gains on these securities in anamount that would be payable if the securities were disposed of on the valuation date.

h. Security Transactions, Investment Income, Expenses and Distributions

Security transactions are accounted for on trade date. Realized gains and losses on security trans-actions are determined on a specific identification basis. Interest income and estimated expensesare accrued daily. Dividends from net investment income are normally declared daily; these dividends may be reinvested or paid monthly to shareholders. Distributions to shareholders aredetermined according to income tax regulations (tax basis). Distributable earnings determined ona tax basis may differ from earnings recorded in accordance with accounting principles generallyaccepted 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. Thesereclassifications have no impact on net assets or the results of operations. Temporary differencesare not reclassified, as they may reverse in subsequent periods.

i. Accounting Estimates

The preparation of financial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities at the date of the financial statements andthe amounts of income and expenses during the reporting period. Actual results could differ fromthose estimates.


26 | Annual Report


j. Guarantees and Indemnifications

Under the Fund’s organizational documents, its officers and trustees are indemnified by the Fundagainst 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 con-tain general indemnification clauses. The Fund’s maximum exposure under these arrangementsis unknown as this would involve future claims that may be made against the Fund that havenot yet occurred. Currently, the Fund expects the risk of loss to be remote.

2. SHARES OF BENEFICIAL INTEREST

At September 30, 2011, there were an unlimited number of shares authorized (without par value).Transactions in the Fund’s shares were as follows:

Year Ended September 30,2011 2010

Shares Amount Shares Amount

Shares sold . . . . . . . . . . . . . . . . . . . . . . 2,847,681 $ 26,655,458 2,463,859 $ 22,012,504Shares issued in reinvestment of

distributions . . . . . . . . . . . . . . . . . . . . 402,173 3,762,036 488,765 4,361,880Shares redeemed . . . . . . . . . . . . . . . . . (3,386,011) (31,587,249) (3,542,454) (31,625,136)

Net increase (decrease) . . . . . . . . . . . . . (136,157) $ (1,169,755) (589,830) $ (5,250,752)

3. TRANSACTIONS WITH AFFILIATES

Franklin Resources, Inc. is the holding company for various subsidiaries that together arereferred 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 managerFranklin Templeton Services, LLC (FT Services) Administrative managerFranklin Templeton Distributors, Inc. (Distributors) Principal underwriterFranklin 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 assetsof the Fund as follows:

Annualized Fee Rate Net Assets

0.40% First $250 million0.38% Over $250 million, up to and including $500 million0.36% In excess of $500 million


Annual Report | 27

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

Front-end sales charges and contingent deferred sales charges (CDSC) do not represent expensesof the Fund. These charges are deducted from the proceeds of sales of Fund shares prior toinvestment or from redemption proceeds prior to remittance, as applicable. Distributors hasadvised the Fund of the following commission transactions related to the sales and redemptionsof the Fund’s shares for the year:

Sales charges retained net of commissions paid to unaffiliated broker/dealers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $29,337

CDSC retained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,676

d. Transfer Agent Fees

For the year ended September 30, 2011, the Fund paid transfer agent fees of $135,958, of which$71,474 was retained by Investor Services.

4. EXPENSE OFFSET ARRANGEMENT

The Fund has entered into an arrangement with its custodian whereby credits realized as a resultof uninvested cash balances are used to reduce a portion of the Fund’s custodian expenses. Duringthe year ended September 30, 2011, there were no credits earned.

5. INCOME TAXES

For tax purposes, capital losses may be carried over to offset future capital gains, if any. AtSeptember 30, 2011, the capital loss carryforwards were as follows:

Capital loss carryforwards expiring in:2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,223,5782013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,584,0502014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,817,0222015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,099,5882016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,076,0952017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,449,0422018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,929,6942019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,155,073

$37,334,142


28 | Annual Report

5. INCOME TAXES (continued)

Under the Regulated Investment Company Modernization Act of 2010, the Fund will be permit-ted to carry forward capital losses incurred in taxable years beginning after December 22, 2010for an unlimited period. Post-enactment capital loss carryforwards will retain their character aseither short-term or long-term capital losses rather than being considered short-term as underprevious law. Any post-enactment capital losses generated will be required to be utilized prior tothe losses incurred in pre-enactment tax years.

For tax purposes, realized capital losses occurring subsequent to October 31 may be deferredand treated as occurring on the first day of the following fiscal year. At September 30, 2011, theFund deferred realized capital losses of $50,529.

The tax character of distributions paid during the years ended September 30, 2011 and 2010,was as follows:

2011 2010

Distributions paid from ordinary income . . . . . . $4,691,899 $5,422,467

At September 30, 2011, the cost of investments, net unrealized appreciation (depreciation), andundistributed ordinary income for income tax purposes were as follows:

Cost of investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,243,113

Unrealized appreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,031,726Unrealized depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,507,087)

Net unrealized appreciation (depreciation) . . . . . . . . . . . . . . $ 524,639

Distributable earnings – undistributed ordinary income . . . . . $ 152,478

Differences between income and/or capital gains as determined on a book basis and a tax basisare primarily due to differing treatments of mortgage dollar rolls and paydown losses.

6. INVESTMENT TRANSACTIONS

Purchases and sales of investments (excluding short term securities) for the year endedSeptember 30, 2011, aggregated $654,086,389 and $650,616,904, respectively.

7. INVESTMENTS IN INSTITUTIONAL FIDUCIARY TRUST MONEY MARKET PORTFOLIO

The Fund invests in the Institutional Fiduciary Trust Money Market Portfolio (Sweep MoneyFund), an open-end investment company managed by Advisers. Management fees paid by theFund are reduced on assets invested in the Sweep Money Fund, in an amount not to exceed themanagement and administrative fees paid by the Sweep Money Fund.


Annual Report | 29

8. CONCENTRATION OF CREDIT RISK

The Fund has 16.0% of its portfolio invested in asset-backed and commercial mortgage-backedsecurities. Investments in these securities may subject the Fund to increased market volatilitywhich may cause the Fund’s net asset value per share to fluctuate. These investments may be lessliquid than other investments held by the Fund.

9. OTHER DERIVATIVE INFORMATION

At September 30, 2011, the Fund has invested in derivative contracts which are reflected on theStatement of Assets and Liabilities as follows:

Asset Derivatives Liability Derivatives

Derivative ContractsNot Accounted for as Statement of Assets and Fair Value Statement of Assets and Fair ValueHedging Instruments Liabilities Locations Amount Liabilities Location Amount

Interest rate contracts . . . . . . Variation margin / Net assets Variation margin / Net assetsconsist of – net unrealized consist of – net unrealized appreciation (depreciation) $ — appreciation(depreciation) $1,508a

aIncludes cumulative appreciation (depreciation) of futures contracts as reported in the Statement of Investments. Only current day’s variation margin is reported within the Statement of Assets and Liabilities.

For the period ended September 30, 2011, the effect of derivative contracts on the Fund’sStatement of Operations was as follows:

Change inUnrealized

Derivative Contracts Realized AppreciationNot Accounted for as Gain (Loss) (Depreciation)Hedging Instruments Statement of Operations Locations for the Year for the Year

Interest rate contracts . . . . . . Net realized gain (loss) from futures contracts / Net change in unrealized appreciation (depreciation) on investments $766,955 $24,477

For the year ended September 30, 2011, the average month end market value of derivatives represented 0.03% of average month end net assets. The average month end number of openderivative contracts for the year was 1.

See Note 1(e) regarding derivative financial instruments.

10. CREDIT FACILITY

The Fund, together with other U.S. registered and foreign investment funds (collectively,Borrowers), managed by Franklin Templeton Investments, are borrowers in a joint syndicatedsenior unsecured credit facility totaling $750 million (Global Credit Facility) which matures onJanuary 20, 2012. This Global Credit Facility provides a source of funds to the Borrowers for


30 | Annual Report

10. CREDIT FACILITY (continued)

temporary and emergency purposes, including the ability to meet future unanticipated or unusu-ally large redemption requests.

Under the terms of the Global Credit Facility, the Fund shall, in addition to interest charged onany borrowings made by the Fund and other costs incurred by the Fund, pay its share of feesand expenses incurred in connection with the implementation and maintenance of the GlobalCredit Facility, based upon its relative share of the aggregate net assets of all of the Borrowers,including an annual commitment fee of 0.08% based upon the unused portion of the GlobalCredit Facility, which is reflected in other expenses on the Statement of Operations. During theyear ended September 30, 2011, the Fund did not use the Global Credit Facility.

11. FAIR VALUE MEASUREMENTS

The Fund follows a fair value hierarchy that distinguishes between market data obtained fromindependent sources (observable inputs) and the Fund’s own market assumptions (unobservableinputs). These inputs are used in determining the value of the Fund’s investments and are sum-marized 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 associatedwith investing in those securities.

For movements between the levels within the fair value hierarchy, the Fund has adopted a policyof recognizing the transfers as of the date of the underlying event which caused the movement.

The following is a summary of the inputs used as of September 30, 2011, in valuing the Fund’sassets and liabilities carried at fair value:

Level 1 Level 2 Level 3 TotalAssets:

Investments in Securities:Mortgage-Backed Securities . . . . . . . . . . $ — $ 98,813,837 $ — $ 98,813,837Asset-Backed Securities and

Commercial Mortgage-Backed Securities . . . . . . . . . . . . . . . . . . . . . . — 24,151,483 — 24,151,483

Short Term Investments . . . . . . . . . . . . . 5,088,632 22,713,800 — 27,802,432

Total Investments in Securities . . . . . . . $5,088,632 $145,679,120 $ — $150,767,752

Liabilities:Financial Futures Contracts . . . . . . . . . . . . 1,508 — — 1,508


Annual Report | 31

12. NEW ACCOUNTING PRONOUNCEMENTS

In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting StandardsUpdate (ASU) No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of EffectiveControl for Repurchase Agreements with the main objective to improve the accounting forrepurchase agreements and other similar agreements that both entitle and obligate a transferorto repurchase or redeem financial assets before their maturity. The ASU modifies the criteria fordetermining effective control of transferred assets and as a result, certain agreements may nowbe accounted for as secured borrowings. The ASU is effective for transactions occurring ininterim and annual periods beginning after December 15, 2011. The Fund is currently reviewingthe requirements and believe the adoption of this ASU will not have a material impact on thefinancial statements.

In May 2011, FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendmentsto Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP andIFRSs. The amendments in the ASU will improve the comparability of fair value measurementspresented and disclosed in financial statements prepared in accordance with U.S. GAAP (GenerallyAccepted Accounting Principles) and IFRS (International Financial Reporting Standards) andinclude new guidance for certain fair value measurement principles and disclosure requirements.The ASU is effective for interim and annual periods beginning after December 15, 2011. TheFund is currently reviewing the requirements and believe the adoption of this ASU will not havea material impact on the financial statements.

13. SUBSEQUENT EVENTS

The Fund has evaluated subsequent events through the issuance of the financial statements anddetermined that no events have occurred that require disclosure.

ABBREVIATIONS

Currency Selected Portfolio

CAD - Canadian Dollar GL - Government LoanPC - Participation CertificatePL - Project LoanSF - Single Family

Franklin Strategic Mortgage PortfolioReport of Independent Registered Public Accounting Firm

32 | Annual 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 ofinvestments, and the related statements of operations and of changes in net assets and the finan-cial highlights present fairly, in all material respects, the financial position of Franklin StrategicMortgage Portfolio (the “Fund”) at September 30, 2011, the results of its operations for theyear then ended, the changes in its net assets for each of the two years in the period then endedand the financial highlights for each of the five years in the period then ended, in conformitywith accounting principles generally accepted in the United States of America. These financialstatements and financial highlights (hereafter referred to as “financial statements”) are theresponsibility of the Fund’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. We conducted our audits of these financial statementsin accordance with the standards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit to obtain reasonable assur-ance about whether the financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimates made by manage-ment, and evaluating the overall financial statement presentation. We believe that our audits,which included confirmation of securities at September 30, 2011 by correspondence with thecustodian and brokers, provide a reasonable basis for our opinion.

PricewaterhouseCoopers LLP

San Francisco, CaliforniaNovember 16, 2011

Franklin Strategic Mortgage PortfolioTax Designation (unaudited)

Annual Report | 33

Under Section 871(k)(1)(C) of the Internal Revenue Code (Code), the Fund designates the maximum amount allowable but no less than $3,450,283 as interest related dividends for purposes of the tax imposed under Section 871(a)(1)(A) of the Code for the fiscal year endedSeptember 30, 2011.

Number of Portfolios inName, Year of Birth Length of Fund Complex Overseenand Address Position Time Served by Board Member* Other Directorships Held

34 | Annual Report

Franklin Strategic Mortgage PortfolioBoard Members and Officers

The name, year of birth and address of the officers and board members, as well as their affiliations, positions held withthe Trust, principal occupations during the past five years and number of portfolios overseen in the Franklin TempletonInvestments fund complex are shown below. Generally, each board member serves until that person’s successor is electedand qualified.

Independent Board Members

Bar-S Foods (meat packing company)(1981-2010).

Harris J. Ashton (1932)One Franklin ParkwaySan Mateo, CA 94403-1906

Trustee Since 1992 132

Principal Occupation During Past 5 Years:Director of various companies; and formerly, Director, RBC Holdings, Inc. (bank holding company) (until 2002); and President, Chief ExecutiveOfficer and Chairman of the Board, General Host Corporation (nursery and craft centers) (until 1998).

ICO Global Communications(Holdings) Limited (satellite company)(2006-2010), Chevron Corporation(global energy company) (1989-2009),Hewlett-Packard Company (technologycompany) (1996-2002), Safeway, Inc.(grocery retailer) (1991-1998) andTransAmerica Corporation (insurancecompany) (1989-1999).

Sam Ginn (1937)One Franklin ParkwaySan Mateo, CA 94403-1906


Principal Occupation During Past 5 Years:Private investor; and formerly, Chairman of the Board, Vodafone AirTouch, PLC (wireless company); Chairman of the Board and ChiefExecutive Officer, AirTouch Communications (cellular communications) (1993-1998) and Pacific Telesis Group (telephone holding company)(1988-1994).

Edith E. Holiday (1952)One Franklin ParkwaySan Mateo, CA 94403-1906


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 theCabinet (1990-1993); General Counsel to the United States Treasury Department (1989-1990); and Counselor to the Secretary and AssistantSecretary for Public Affairs and Public Liaison – United States Treasury Department (1988-1989).

Hess Corporation (exploration andrefining of oil and gas), H.J. HeinzCompany (processed foods and alliedproducts), RTI International Metals,Inc. (manufacture and distribution of titanium), Canadian NationalRailway (railroad) and WhiteMountains Insurance Group, Ltd.(holding company).


Annual Report | 35

Boeing Capital Corporation (aircraftfinancing).

J. Michael Luttig (1954)One Franklin ParkwaySan Mateo, CA 94403-1906


Principal Occupation During Past 5 Years:Executive Vice President, General Counsel and member of Executive Council, The Boeing Company; and formerly, Federal Appeals CourtJudge, U.S. Court of Appeals for the Fourth Circuit (1991-2006).

Hess Corporation (exploration andrefining of oil and gas).

Frank A. Olson (1932)One Franklin ParkwaySan 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).

NoneJohn B. Wilson (1959)One Franklin ParkwaySan Mateo, CA 94403-1906

LeadIndependentTrustee

Trustee since2007 and LeadIndependentTrustee since2008

107

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 VicePresident – 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).

Cbeyond, Inc. (business commu-nications provider), The SouthernCompany (energy company) and The Washington Post Company (education and media organization).

Larry D. Thompson (1945)One Franklin ParkwaySan Mateo, CA 94403-1906


Principal Occupation During Past 5 Years:John A. Sibley Professor of Corporate and Business Law, University of Georgia School of Law (2011); and formerly, Senior Vice President –Government Affairs, General Counsel and Secretary, PepsiCo, Inc. (consumer products) (2004-May 2011); Senior Fellow of The BrookingsInstitution (2003-2004); Visiting Professor, University of Georgia School of Law (2004); and Deputy Attorney General, U.S. Department ofJustice (2001-2003).

None**Charles B. Johnson (1933)One Franklin ParkwaySan Mateo, CA 94403-1906

Trustee andChairman ofthe Board

Trustee since1992 andChairman of theBoard since 1993

132

Principal Occupation During Past 5 Years:Chairman of the Board, Member – Office of the Chairman and Director, Franklin Resources, Inc.; and officer and/or director or trustee, asthe case may be, of some of the other subsidiaries of Franklin Resources, Inc. and of 41 of the investment companies in Franklin TempletonInvestments.

Interested Board Members and Officers



36 | Annual Report

Not ApplicableJames M. Davis (1952)One Franklin ParkwaySan Mateo, CA 94403-1906

ChiefComplianceOfficer andVice President– AMLCompliance

Chief ComplianceOfficer since 2004and VicePresident – AMLCompliance since2006

Not Applicable

Principal Occupation During Past 5 Years:Director, Global Compliance, Franklin Resources, Inc.; and officer of 45 of the investment companies in Franklin Templeton Investments.

None**Gregory E. Johnson (1961)One Franklin ParkwaySan Mateo, CA 94403-1906


Principal Occupation During Past 5 Years:Director, President and Chief Executive Officer, Franklin Resources, Inc.; and officer and/or director or trustee, as the case may be, of someof the other subsidiaries of Franklin Resources, Inc. and of 33 of the investment companies in Franklin Templeton Investments.

Not ApplicableLaura F. Fergerson (1962)One Franklin ParkwaySan Mateo, CA 94403-1906

ChiefExecutiveOfficer –Finance andAdministration

Since 2009 Not Applicable

Principal Occupation During Past 5 Years:Senior Vice President, Franklin Templeton Services, LLC; officer of 45 of the investment companies in Franklin Templeton Investments; andformerly, Director and member of Audit and Valuation Committees, Runkel Funds, Inc. (2003-2004); Assistant Treasurer of most of theinvestment companies in Franklin Templeton Investments (1997-2003); and Vice President, Franklin Templeton Services, LLC (1997-2003).

Not ApplicableGaston Gardey (1967)One Franklin ParkwaySan Mateo, CA 94403-1906

Treasurer,Chief FinancialOfficer andChiefAccountingOfficer


Principal Occupation During Past 5 Years:Director, Fund Accounting, Franklin Templeton Investments; and officer of 27 of the investment companies in Franklin Templeton Investments.

Not ApplicableAliya S. Gordon (1973)One Franklin ParkwaySan Mateo, CA 94403-1906

Vice President Since 2009 Not Applicable

Principal Occupation During Past 5 Years:Senior Associate General Counsel, Franklin Templeton Investments; officer of 45 of the investment companies in Franklin TempletonInvestments; and formerly, Litigation Associate, Steefel, Levitt & Weiss, LLP (2000-2004).


Annual Report | 37

Not ApplicableChristopher J. Molumphy (1962)One Franklin ParkwaySan Mateo, CA 94403-1906

President andChiefExecutiveOfficer –InvestmentManagement


Principal Occupation During Past 5 Years:Director and Executive Vice President, Franklin Advisers, Inc.; Executive Vice President, Franklin Templeton Institutional, LLC; and officer ofsome of the other subsidiaries of Franklin Resources, Inc. and of 22 of the investment companies in Franklin Templeton Investments.

Not ApplicableRobert C. Rosselot (1960)300 S.E. 2nd StreetFort Lauderdale, FL 33301-1923


Principal Occupation During Past 5 Years:Senior Associate General Counsel, Franklin Templeton Investments; Assistant Secretary, Franklin Resources, Inc.; Vice President andSecretary, Templeton Investment Counsel, LLC; Vice President, Secretary and Trust Officer, Fiduciary Trust International of the South; andofficer of 45 of the investment companies in Franklin Templeton Investments.

Not ApplicableKaren L. Skidmore (1952)One Franklin ParkwaySan Mateo, CA 94403-1906

Vice Presidentand Secretary


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.

Not ApplicableDavid P. Goss (1947)One Franklin ParkwaySan Mateo, CA 94403-1906


Principal Occupation During Past 5 Years:Senior Associate General Counsel, Franklin Templeton Investments; and officer and/or director, as the case may be, of some of the othersubsidiaries of Franklin Resources, Inc. and of 45 of the investment companies in Franklin Templeton Investments.

Not ApplicableSteven J. Gray (1955)One Franklin ParkwaySan 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 ofthe investment companies in Franklin Templeton Investments.


38 | Annual Report

Not ApplicableLori A. Weber (1964)300 S.E. 2nd StreetFort Lauderdale, FL 33301-1923

Vice President Since May 2011 Not Applicable

Principal Occupation During Past 5 Years:Associate General Counsel, Franklin Templeton Investments; Assistant Secretary, Franklin Resources, Inc.; Vice President and AssistantSecretary, Templeton Investment Counsel, LLC; and officer of 45 of the investment companies in Franklin Templeton Investments.

Not ApplicableCraig S. Tyle (1960)One Franklin ParkwaySan 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 portfolioshave 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 ofFranklin 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 ofthe Fund under the federal securities laws due to his position as an officer and director of Resources.

Note 1: Charles B. Johnson is the father 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 suchfinancial 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 anexpert 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 aMember 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 under-standing 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 thoseof 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 anindependent 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 maycall (800) DIAL BEN/342-5236 to request the SAI.

Franklin Strategic Mortgage PortfolioShareholder Information

Annual Report | 39

Proxy Voting Policies and Procedures

The Trust’s investment manager has established Proxy Voting Policies and Procedures (Policies) thatthe Trust uses to determine how to vote proxies relating to portfolio securities. Shareholders mayview the Trust’s complete Policies online at franklintempleton.com. Alternatively, shareholders mayrequest copies of the Policies free of charge by calling the Proxy Group collect at (954) 527-7678or by sending a written request to: Franklin Templeton Companies, LLC, 300 S.E. 2nd Street, Fort Lauderdale, FL 33301, Attention: Proxy Group. Copies of the Trust’s proxy voting recordsare also made available online at franklintempleton.com and posted on the U.S. Securities andExchange Commission’s website at sec.gov and reflect the most recent 12-month period endedJune 30.

Quarterly Statement of Investments

The Trust files a complete statement of investments with the U.S. Securities and Exchange Commissionfor the first and third quarters for each fiscal year on Form N-Q. Shareholders may view the filedForm N-Q by visiting the Commission’s website at sec.gov. The filed form may also be viewed andcopied at the Commission’s Public Reference Room in Washington, DC. Information regarding theoperations of the Public Reference Room may be obtained by calling (800) SEC-0330.

Householding of Reports and Prospectuses

You will receive the Fund’s financial reports every six months as well as an annual updated sum-mary prospectus (prospectus available upon request). To reduce Fund expenses, we try to identifyrelated shareholders in a household and send only one copy of the financial reports and summaryprospectus. This process, called “householding,” will continue indefinitely unless you instruct usotherwise. If you prefer not to have these documents householded, please call us at (800) 632-2301.At any time you may view current prospectuses/summary prospectuses and financial reports onour website. If you choose, you may receive these documents through electronic delivery.

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Franklin Templeton FundsLiterature Request. To receive a summary prospectus and/or prospectus, please call us at (800) DIAL BEN/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 a 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.

VALUEFranklin All Cap Value FundFranklin Balance Sheet Investment FundFranklin Large Cap Value FundFranklin MicroCap Value Fund1

Franklin MidCap Value FundFranklin Small Cap Value FundMutual Beacon FundMutual Quest FundMutual Recovery Fund2

Mutual Shares Fund

BLENDFranklin Focused Core Equity FundFranklin Large Cap Equity FundFranklin Rising Dividends Fund

GROWTHFranklin DynaTech FundFranklin Flex Cap Growth FundFranklin Growth FundFranklin Growth Opportunities FundFranklin Small Cap Growth FundFranklin Small-Mid Cap Growth Fund

SECTORFranklin Biotechnology Discovery FundFranklin Global Real Estate FundFranklin Gold & Precious Metals FundFranklin Natural Resources FundFranklin Real Estate Securities FundFranklin Utilities FundMutual Financial Services Fund

GLOBALFranklin World Perspectives FundMutual Global Discovery FundTempleton Global Opportunities TrustTempleton Global Smaller Companies FundTempleton Growth FundTempleton World Fund

1. The fund is closed to new investors. Existing shareholders and select retirement plans cancontinue adding to their accounts.2. The fund is a continuously offered, closed-end fund. Shares may be purchased daily; thereis no daily redemption. However, each quarter, pending board approval, the fund will authorizethe repurchase of 5%–25% of the outstanding number of shares. Investors may tender all ora portion of their shares during the tender period.3. Effective 7/1/11, Templeton Income Fund changed its name to Templeton Global BalancedFund. Additionally, the fund changed its goal and pricing structure. Under normalcircumstances, the fund will invest: at least 25% of its assets in fixed income senior securities

and at least 25% of its assets in equity securities; at least 40% of its assets in non-U.S.investments; and in issuers located in at least three different countries (including the U.S.).4. An investment in the fund is neither insured nor guaranteed by the U.S. government or byany other entity or institution.5. For investors subject to the alternative minimum tax, a small portion of fund dividends maybe taxable. Distributions of capital gains are generally taxable.6. The fund invests primarily in insured municipal securities.7. The funds of the Franklin Templeton Variable Insurance Products Trust are generally availableonly through insurance company variable contracts.

AlabamaArizonaCalifornia (4 funds)ColoradoConnecticutFloridaGeorgiaKentuckyLouisianaMarylandMassachusettsMichigan

MinnesotaMissouriNew JerseyNew York (2 funds)North CarolinaOhioOregonPennsylvaniaTennesseeVirginia

INSURANCE FUNDSFranklin Templeton Variable Insurance Products Trust7

10/11 Not part of the annual report

INTERNATIONALFranklin India Growth FundFranklin International Growth FundFranklin International Small Cap Growth FundMutual European FundMutual International FundTempleton Asian Growth FundTempleton BRIC FundTempleton China World FundTempleton Developing Markets TrustTempleton Emerging Markets Small Cap FundTempleton Foreign FundTempleton Foreign Smaller Companies FundTempleton Frontier Markets Fund

HYBRIDFranklin Balanced FundFranklin Convertible Securities FundFranklin Equity Income FundFranklin Income FundTempleton Emerging Markets Balanced FundTempleton Global Balanced Fund3

ASSET ALLOCATIONFranklin Templeton Corefolio® Allocation FundFranklin Templeton Founding Funds Allocation FundFranklin Templeton Conservative Allocation FundFranklin Templeton Growth Allocation FundFranklin Templeton Moderate Allocation FundFranklin Templeton 2015 Retirement Target FundFranklin Templeton 2025 Retirement Target FundFranklin Templeton 2035 Retirement Target FundFranklin Templeton 2045 Retirement Target FundFranklin Templeton Global Allocation Fund

FIXED INCOMEFranklin Adjustable U.S. Government Securities Fund4

Franklin Floating Rate Daily Access FundFranklin High Income Fund

Franklin Limited Maturity U.S. GovernmentSecurities Fund4

Franklin Low Duration Total Return FundFranklin Real Return FundFranklin Strategic Income FundFranklin Strategic Mortgage PortfolioFranklin Templeton Hard Currency FundFranklin Total Return FundFranklin U.S. Government Securities Fund4

Templeton Global Bond FundTempleton Global Total Return FundTempleton International Bond Fund

TAX-FREE INCOME5

NationalDouble Tax-Free Income FundFederal Tax-Free Income FundHigh Yield Tax-Free Income FundInsured Tax-Free Income Fund6

Limited-/ Intermediate-TermCalifornia Intermediate-Term Tax-Free Income FundFederal Intermediate-Term Tax-Free Income FundFederal Limited-Term Tax-Free Income FundNew York Intermediate-Term Tax-Free Income Fund

State-Specific

< GAIN FROM OUR PERSPECTIVE® >

VALUE BLEND GROWTH SECTOR GLOBAL INTERNAT IONAL HYBRID ASSET ALLOCAT ION F IXED INCOME TAX-FREE INCOME

© 2011 Franklin Templeton Investments. All rights reserved. 157 A 11/11

Annual Report and Shareholder Letter

Franklin Strategic Mortgage Portfolio

Investment ManagerFranklin Advisers, Inc.

DistributorFranklin Templeton Distributors, Inc.(800) DIAL BEN®/342-5236franklintempleton.com

Shareholder Services(800) 632-2301

Authorized for distribution only when accompanied or preceded by a summary prospectus and/or prospectus.Investors should carefully consider a fund’s investment goals, risks, charges and expenses before investing. A 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 andaccessed. These calls can be identified by the presence of a regular beeping tone.

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