-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LWioDzf5qBLfb/yk7jtREnFkHK2AIP0F/voY1fKXKbcid4pGC7wpItRNgXOs9cCM r49kaKxS7uETyXkERY+q0A== 0000757010-99-000011.txt : 19990702 0000757010-99-000011.hdr.sgml : 19990702 ACCESSION NUMBER: 0000757010-99-000011 CONFORMED SUBMISSION TYPE: 497 PUBLIC DOCUMENT COUNT: 1 FILED AS OF DATE: 19990701 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FRANKLIN TAX FREE TRUST CENTRAL INDEX KEY: 0000757010 STANDARD INDUSTRIAL CLASSIFICATION: [] STATE OF INCORPORATION: MA FISCAL YEAR END: 0228 FILING VALUES: FORM TYPE: 497 SEC ACT: SEC FILE NUMBER: 002-94222 FILM NUMBER: 99657704 BUSINESS ADDRESS: STREET 1: 777 MARINERS ISLAND BLVD CITY: SAN MATEO STATE: CA ZIP: 94404 BUSINESS PHONE: 4153122000 MAIL ADDRESS: STREET 1: 777 MARINERS ISLAND BLVD CITY: SAN MATEO STATE: CA ZIP: 94404 497 1 PROSPECTUS FRANKLIN TAX-FREE TRUST INVESTMENT STRATEGY TAX-FREE INCOME FRANKLIN ARIZONA INSURED TAX-FREE INCOME FUND FRANKLIN FLORIDA INSURED TAX-FREE INCOME FUND FRANKLIN INSURED TAX-FREE INCOME FUND FRANKLIN MASSACHUSETTS INSURED TAX-FREE INCOME FUND FRANKLIN MICHIGAN INSURED TAX-FREE INCOME FUND FRANKLIN MINNESOTA INSURED TAX-FREE INCOME FUND FRANKLIN OHIO INSURED TAX-FREE INCOME FUND JULY 1, 1999 [Insert Franklin Templeton Ben Head] The SEC has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. CONTENTS THE FUNDS [Begin callout] Information about each fund you should know before investing [End callout] 2 Goals and Strategies 4 Main Risks 7 Performance 14 Fees and Expenses 17 Management 19 Distributions and Taxes 21 Financial Highlights YOUR ACCOUNT [Begin callout] Information about sales charges, account transactions and services [End callout] 27 Choosing a Share Class 31 Buying Shares 33 Investor Services 35 Selling Shares 37 Account Policies 40 Questions FOR MORE INFORMATION [Begin callout] Where to learn more about each fund [End callout] Back Cover THE FUNDS [Insert graphic of bullseye and arrows] GOALS AND STRATEGIES GOALS Each fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. Each state fund also tries to provide a maximum level of income exempt from personal income taxes, if any, for resident shareholders of the fund's state. PRINCIPAL INVESTMENTS Each fund normally invests predominately in municipal securities whose interest is free from federal income taxes, including the federal alternative minimum tax, and, in the case of each state fund, the personal income taxes, if any, of the fund's state. Although each fund tries to invest all of its assets in tax-free securities, it is possible, although not anticipated, that up to 20% of its assets may be in securities that pay taxable interest. [Begin callout] MUNICIPAL SECURITIES are issued by state and local governments, their agencies and authorities, as well as by the District of Columbia and U.S. territories and possessions, to borrow money for various public and private projects. The issuer pays a fixed, floating or variable rate of interest, and must repay the amount borrowed (the "principal") at maturity. [End callout] Each fund invests at least 65% of its total assets in insured municipal securities, and under normal circumstances tries to invest more than 65% in insured securities. Insured municipal securities are covered by insurance policies that guarantee the timely payment of principal and interest. Generally, the fund buys insured municipal securities only if they are covered by policies issued by AAA-rated municipal bond insurers. Currently, there are four municipal bond insurers with a AAA rating. The fund pays insurance premiums either directly or indirectly, which increases the credit safety of its insured investments, but decreases its yield. Each fund may invest the balance of its assets in the following types of securities: (i) uninsured municipal securities secured by an escrow or trust account containing direct U.S. government obligations; (ii) securities rated in one of the top three ratings by U.S. nationally recognized rating services (or comparable unrated securities), which may include uninsured securities and insured securities covered by policies issued by insurers with a rating below AAA but not below A; or (iii) uninsured short-term, tax-exempt securities rated in the top rating, pending investment in longer-term municipal securities. Each fund may only invest up to 20% of its total assets in the type of securities described in (ii) above. The manager selects securities that it believes will provide the best balance between risk and return within a fund's range of allowable investments and typically uses a buy and hold strategy. This means it holds securities in the fund's portfolio for income purposes, rather than trading securities for capital gains, although the manager may sell a security at any time if it believes it could help the fund meet its goal. The manager also may consider the cost of insurance when selecting securities for a fund. Each fund also may invest in municipal lease obligations, which generally are issued to finance the purchase of public property. The property is leased to a state or local government and the lease payments are used to pay the interest on the obligations. These differ from other municipal securities because the money to make the lease payments must be set aside each year or the lease can be cancelled without penalty. If this happens, investors who own the obligations may not be paid. TEMPORARY INVESTMENTS The manager may take a temporary defensive position when it believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist. Under these circumstances, a fund may be unable to pursue its investment goals, because it may not invest or may invest substantially less in tax-free securities or, in the case of the state funds, in municipal securities of the fund's state. IT IS IMPORTANT TO NOTE THAT INSURANCE DOES NOT GUARANTEE THE MARKET VALUE OF AN INSURED SECURITY, OR THE FUND'S SHARE PRICE OR DISTRIBUTIONS, AND SHARES OF THE FUND ARE NOT INSURED. [Insert graphic of chart with line going up and down] MAIN RISKS INCOME Since each fund can only distribute what it earns, the fund's distributions to shareholders may decline when interest rates fall. CREDIT There is the possibility that an issuer will be unable to make interest payments and repay principal. Changes in an issuer's financial strength or in a security's credit rating may affect a security's value and, thus, impact fund performance. Many of each fund's portfolio securities are supported by credit enhancements, which may be provided by either U.S. or foreign entities. These securities have the credit risk of the entity providing the credit support. A change in the credit rating of any one or more of the municipal bond insurers that insure securities in the fund's portfolio may affect the value of the securities they insure, the fund's share price and fund performance. Credit support provided by a foreign entity may be less certain because of the possibility of adverse foreign economic, political or legal developments that may affect the ability of that entity to meet its obligations. [Begin callout] Because interest rates and municipal security prices fluctuate, the amount of the fund's distributions, the fund's yield, and the value of your investment in the fund will go up and down. This means you could lose money over short or even extended periods. [End callout] INTEREST RATE When interest rates go up, municipal security prices fall. The opposite is also true: municipal security prices go up when interest rates fall. In general, securities with longer maturities are more sensitive to these price changes. CALL There is the likelihood that a security will be prepaid (called) before maturity. An issuer is more likely to call its securities when interest rates are falling, because the issuer can issue new securities with lower interest payments. If a security is called, the fund may have to replace it with a lower-yielding security. At any time, each fund may have a large amount of its assets invested in municipal securities subject to call risk, including escrow-secured or defeased bonds. A call of some or all of these securities may lower the fund's income and yield and its distributions to shareholders. MARKET A security's value may be reduced by market activity or the results of supply and demand. This is a basic risk associated with all securities. When there are more sellers than buyers, prices tend to fall. Likewise, when there are more buyers than sellers, prices tend to go up. Each fund may invest more than 25% of its assets in municipal securities that finance similar types of projects, such as hospitals, housing, industrial development, transportation or pollution control. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects, thereby increasing market risk. WHEN-ISSUED AND DELAYED DELIVERY TRANSACTIONS Municipal securities may be issued on a when-issued or delayed delivery basis, where payment and delivery take place at a future date. Since the market price of the security may fluctuate during the time before payment and delivery, the fund assumes the risk that the value of the security at delivery may be more or less than the purchase price. DIVERSIFICATION The Arizona and Florida Funds are non-diversified funds. They may invest a greater portion of their assets in the municipal securities of one issuer than a diversified fund. These funds may be more sensitive to economic, business, political or other changes affecting similar issuers or securities, which may result in greater fluctuation in the value of their shares. The funds, however, intend to meet certain tax diversification requirements. The other funds are all diversified funds. Each state fund may involve more risk than an investment in a fund that does not focus on securities of a single state. The Franklin Insured Tax-Free Income Fund is diversified nationally and will not invest more than 25% of its total assets in the municipal securities of any one state or territory. STATE Since each state fund invests heavily in municipal securities of its state, events in that state are likely to affect the fund's investments and its performance. These events may include economic or political policy changes, tax base erosion, state constitutional limits on tax increases, budget deficits and other financial difficulties, and changes in the credit ratings assigned to the state's municipal issuers. A negative change in any one of these or other areas could affect the ability of a state's municipal issuers to meet their obligations. It is important to remember that economic, budget and other conditions within a state are unpredictable and can change at any time. To the extent the Franklin Insured Tax-Free Income Fund is invested in a state, events in that state may affect the fund's investments and its performance. U.S. TERRITORIES Each fund may invest in municipal securities issued by U.S. territories. As with state municipal securities, events in any of these territories where a fund is invested may affect the fund's investments and its performance. YEAR 2000 When evaluating current and potential portfolio positions, Year 2000 is one of the factors the funds' manager considers. Municipal issuers generally are not required to report on their Year 2000 readiness. This makes it more difficult for the manager to evaluate their readiness. There have been reports, however, that many municipal issuers are behind in their efforts to address the Year 2000 problem. The manager, of course, cannot audit each issuer and its major suppliers to verify their Year 2000 readiness. The manager is making efforts, however, to contact the issuers of municipal securities held by the funds to try to assess their Year 2000 readiness. If an issuer in which a fund is invested is adversely affected by Year 2000 problems, it is possible that the issuer's ability to make timely interest and principal payments also will be affected, at least temporarily. This may affect both the amount and timing of the fund's distributions and the fund's performance. It also is likely that the price of the issuer's securities will be adversely affected. A decrease in the value of one or more of the fund's portfolio holdings will have a similar impact on the fund's performance. Please see page 18 for more information. More detailed information about the funds, their policies (including temporary investments), risks and municipal securities ratings can be found in the funds' Statement of Additional Information (SAI). [Begin callout] Mutual fund shares are not deposits or obligations of, or guaranteed or endorsed by, any bank, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency of the U.S. government. Mutual fund shares involve investment risks, including the possible loss of principal. [End callout] [Insert graphic of bull and bear] PERFORMANCE The bar charts and tables below show the volatility of each fund's returns, which is one indicator of the risks of investing in a fund. The bar charts show changes in each fund's returns from year to year over the calendar years shown. The tables show how each fund's average annual total returns compare to those of a broad-based securities market index. Of course, past performance cannot predict or guarantee future results. ARIZONA FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] - -8.26% 21.20% 8.69% 4.59% 6.31% 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 9.53% WORST QUARTER: Q1 '94 - -7.89% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 SINCE INCEPTION 1 YEAR 5 YEARS (4/30/93) - ------------------------------------------------------------------------------- Arizona Fund 2 1.76% 5.17% 5.99% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 6.77% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.79%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. FLORIDA FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] - -9.85% 21.24 8.00% 5.02% 6.67% 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 9.30% WORST QUARTER: Q1 '94 - -8.79% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 SINCE INCEPTION 1 YEAR 5 YEARS (4/30/93) - ------------------------------------------------------------------------------- Florida Fund 2 2.16% 4.84% 5.46% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 6.77% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.68%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. INSURED FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.99% 6.57% 11.35% 9.38% 11.83% -3.59% 13.60% 4.18% 8.11% 6.04% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q2 '89 5.68% WORST QUARTER: Q1 '94 - -4.22% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------- Insured Fund - Class A 2 1.51% 4.61% 7.18% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------- Insured Fund - Class C 2 3.36% 6.25% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.83% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MASSACHUSETTS FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.12% 5.10% 11.46% 8.98% 11.79% -3.63% 14.06% 8.53% 4.21% 5.39% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.87% WORST QUARTER: Q1 '97 - -4.53% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------- Massachusetts Fund - Class A 2 0.93% 4.64% 6.93% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------- Massachusetts Fund - Class C 2 2.90% 6.18% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.95% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MICHIGAN FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.49% 6.10% 10.96% 9.45% 12.09% -3.93% 13.83% 8.87% 3.58% 6.47% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q2 '89 5.81% WORST QUARTER: Q1 '97 - -4.60% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------- Michigan Fund - Class A 2 1.95% 4.69% 7.12% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------- Michigan Fund - Class C 2 3.90% 6.44% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.11% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MINNESOTA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.46% 5.82% 10.86% 8.62% 10.98% -3.55% 13.31% 3.49% 7.69% 5.68% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.70% WORST QUARTER: Q1 '94 - -3.83% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------- Minnesota Fund - Class A 2 1.19% 4.26% 6.67% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------- Minnesota Fund - Class C 2 3.14% 5.72% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.88% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. OHIO FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.25% 6.64% 10.95% 8.98% 12.47% -4.48% 14.34% 4.47% 8.16% 5.94% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 6.09% WORST QUARTER: Q1 '94 - -4.75% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------- Ohio Fund - Class A 2 1.46% 4.60% 7.09% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------- Ohio Fund - Class C 2 3.25% 6.37% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.96% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. [Insert graphic of percentage sign] FEES AND EXPENSES This table describes the fees and expenses that you may pay if you buy and hold shares of a fund. SHAREHOLDER FEES (FEES PAID DIRECTLY FROM YOUR INVESTMENT)
ARIZONA FLORIDA INSURED MASSACHUSETTS MICHIGAN MINNESOTA OHIO CLASS A 1 FUND FUND FUND FUND FUND FUND FUND - ------------------------------------------------------------------------------------------------- Maximum sales charge (load) as a percentage of offering price 4.25% 4.25% 4.25% 4.25% 4.25% 4.25% 4.25% Load imposed on purchases 4.25% 4.25% 4.25% 4.25% 4.25% 4.25% 4.25% Maximum deferred sales charge (load) 2 NONE NONE NONE NONE NONE NONE NONE Exchange fee NONE NONE $5.00 4 NONE NONE NONE NONE CLASS C 1 - -------------------------------------------------------------------------------------------------- Maximum sales charge (load) as a percentage of offering price - - 1.99% 1.99% 1.99% 1.99% 1.99% Load imposed on purchases - - 1.00% 1.00% 1.00% 1.00% 1.00% Maximum deferred sales charge (load) 3 - - 0.99% 0.99% 0.99% 0.99% 0.99% Exchange fee - - $5.00 4 NONE NONE NONE NONE Please see "Choosing a Share Class" on page 27 for an explanation of how and when these sales charges apply. ANNUAL FUND OPERATING EXPENSES (EXPENSES DEDUCTED FROM FUND ASSETS) ARIZONA FLORIDA INSURED MASSACHUSETTS MICHIGAN MINNESOTA OHIO CLASS A 1 FUND FUND FUND FUND FUND FUND FUND - -------------------------------------------------------------------------------------------------- Management fees 0.66% 5 0.62% 5 0.47% 0.52% 0.47% 0.50% 0.48% Distribution and service (12b-1) fees 6 0.10% 0.10% 0.09% 0.09% 0.09% 0.09% 0.09% Other expenses 0.08% 0.07% 0.06% 0.07% 0.07% 0.08% 0.08% Total annual fund operating expenses 0.84% 5 0.79% 5 0.62% 0.68% 0.63% 0.67% 0.65% CLASS C 1 - ------------------------------------------------------------------------------------------------- Management fees - - 0.47% 0.52% 0.47% 0.50% 0.48% Distribution and service (12b-1 fees) 6 - - 0.65% 0.65% 0.65% 0.65% 0.65% Other expenses - - 0.06% 0.07% 0.07% 0.08% 0.08% Total annual fund operating expenses - - 1.18% 1.24% 1.19% 1.23% 1.21% 1. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. 2. Except for investments of $1 million or more (see page 27). 3. This is equivalent to a charge of 1% based on net asset value. 4. This fee is only for market timers (see page 38). 5. For the fiscal year ended February 28, 1999, the manager had agreed in advance to limit its management fees. With this reduction, management fees were 0.19% for the Arizona Fund and 0.25% for the Florida Fund, and total annual fund operating expenses were 0.37% for the Arizona Fund and 0.42% for the Florida Fund. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. 6. Because of the distribution and service (12b-1) fees, over the long term you may indirectly pay more than the equivalent of the maximum permitted initial sales charge. EXAMPLE This example can help you compare the cost of investing in a fund with the cost of investing in other mutual funds. The example assumes you invest $10,000 for the periods shown and then sell all of your shares at the end of those periods. The example also assumes your investment has a 5% return each year and the fund's operating expenses remain the same. Although your actual costs may be higher or lower, based on these assumptions your costs would be: ARIZONA FLORIDA INSURED MASSACHUSETTS MICHIGAN MINNESOTA OHIO FUND FUND FUND FUND FUND FUND FUND - -------------------------------------------------------------------------------------------- CLASS A 1 Year 1 $507 $502 $486 $492 $487 $491 $489 3 Years $682 $667 $615 $633 $618 $630 $624 5 Years $871 $845 $756 $788 $761 $782 $772 10 Years $1,418 $1,361 $1,166 $1,236 $1,178 $1,224 $1,201 CLASS C 1 Year 2 - - $317 $323 $318 $322 $320 3 Years - - $471 $489 $474 $486 $480 5 Years - - $743 $774 $748 $769 $758 10 Years - - $1,517 $1,585 $1,529 $1,574 $1,551
1. Assumes a contingent deferred sales charge (CDSC) will not apply. 2. For the same Class C investment, your costs would be $219 for the Insured Fund, $225 for the Massachusetts Fund, $220 for the Michigan Fund, $224 for the Minnesota Fund, and $222 for the Ohio Fund if you did not sell your shares at the end of the first year. Your costs for the remaining periods would be the same. [Insert graphic of briefcase] MANAGEMENT Franklin Advisers, Inc. (Advisers), 777 Mariners Island Blvd., San Mateo, CA 94404, is each fund's investment manager. Together, Advisers and its affiliates manage over $227 billion in assets. The team responsible for the funds' management is: THOMAS KENNY, EXECUTIVE VICE PRESIDENT OF ADVISERS Mr. Kenny has been an analyst or portfolio manager of the Arizona and Florida Funds since their inception and the Insured, Massachusetts, Michigan, Minnesota and Ohio Funds since 1987. He is the Director of Franklin's Municipal Bond Department. He joined the Franklin Templeton Group in 1986. SHEILA AMOROSO, SENIOR VICE PRESIDENT OF ADVISERS Ms. Amoroso has been an analyst or portfolio manager of the Insured, Michigan and Minnesota Funds since 1987. She joined the Franklin Templeton Group in 1986. CARRIE HIGGINS, PORTFOLIO MANAGER OF ADVISERS Ms. Higgins has been an analyst or portfolio manager of the Arizona Fund since its inception. She joined the Franklin Templeton Group in 1990. JOHN POMEROY, VICE PRESIDENT OF ADVISERS Mr. Pomeroy has been an analyst or portfolio manager of the Arizona and Florida Funds since their inception and the Insured, Massachusetts, Michigan, Minnesota and Ohio Funds since 1989. He joined the Franklin Templeton Group in 1986. FRANCISCO RIVERA, PORTFOLIO MANAGER OF ADVISERS Mr. Rivera has been an analyst or portfolio manager of the Massachusetts Fund since 1996. He joined the Franklin Templeton Group in 1994. STELLA WONG, VICE PRESIDENT OF ADVISERS Ms. Wong has been an analyst or portfolio manager of the Florida Fund since its inception and the Ohio Fund since 1986. She joined the Franklin Templeton Group in 1986. Each fund pays the manager a fee for managing the fund's assets and making its investment decisions. For the fiscal year ended February 28, 1999, the funds paid the following management fees to the manager: MANAGEMENT FEES - ------------------------------------------------------------------------------- Arizona Fund 0.19% 1 Florida Fund 0.25% 1 Insured Fund 0.47% Massachusetts Fund 0.52% Michigan Fund 0.47% Minnesota Fund 0.50% Ohio Fund 0.48% 1. Management fees, before any advance waiver, were 0.66% for the Arizona Fund and 0.62% for the Florida Fund. Under an agreement by the manager to limit its fees, the Arizona and Florida Funds paid the management fees shown. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. YEAR 2000 PROBLEM Each fund's business operations depend on a worldwide network of computer systems that contain date fields, including securities trading systems, securities transfer agent operations and stock market links. Many of the systems currently use a two digit date field to represent the date, and unless these systems are changed or modified, they may not be able to distinguish the Year 1900 from the Year 2000 (commonly referred to as the Year 2000 problem). In addition, the fact that the Year 2000 is a leap year may create difficulties for some systems. When the Year 2000 arrives, the funds' operations could be adversely affected if the computer systems used by the manager, its service providers and other third parties it does business with are not Year 2000 ready. For example, the funds' portfolio and operational areas could be impacted, including securities trade processing, interest and dividend payments, securities pricing, shareholder account services, reporting, custody functions and others. The funds' manager and its affiliated service providers are making a concerted effort to take steps they believe are reasonably designed to address their Year 2000 problems. Of course, the funds' ability to reduce the effects of the Year 2000 problem is also very much dependent upon the efforts of third parties over which the funds and their manager may have no control. [Insert graphic of dollar signs and stacks of coins] DISTRIBUTIONS AND TAXES INCOME AND CAPITAL GAINS DISTRIBUTIONS Each fund declares dividends daily from its net investment income and pays them monthly on or about the 20th day of the month. Your account may begin to receive dividends on the day after we receive your investment and will continue to receive dividends through the day we receive a request to sell your shares. Capital gains, if any, may be distributed twice a year. The amount of these distributions will vary and there is no guarantee the fund will pay dividends. Please keep in mind that if you invest in a fund shortly before the fund deducts a capital gain distribution from its net asset value, you will receive some of your investment back in the form of a taxable distribution. TAX CONSIDERATIONS Fund distributions will consist primarily of exempt-interest dividends from interest earned on municipal securities. In general, exempt-interest dividends are exempt from federal income tax. Each fund, however, may invest a portion of its assets in securities that pay income that is not tax-exempt. Fund distributions from such income are taxable to you as ordinary income. Any capital gains a fund distributes are taxable to you as long-term capital gains no matter how long you have owned your shares. Distributions of ordinary income or capital gains are taxable whether you reinvest your distributions in additional fund shares or receive them in cash. [Begin callout] BACKUP WITHHOLDING By law, a fund must withhold 31% of your taxable distributions and proceeds if you do not provide your correct social security or taxpayer identification number, or if the IRS instructs a fund to do so. [End callout] Every January, you will receive a statement that shows the tax status of distributions you received for the previous year. Distributions declared in December but paid in January are taxable as if they were paid in December. When you sell your shares of a fund, you may have a capital gain or loss. For tax purposes, an exchange of your fund shares for shares of a different Franklin Templeton Fund is the same as a sale. The individual tax rate on any gain from the sale or exchange of your shares depends on how long you have held your shares. Exempt-interest dividends are taken into account when determining the taxable portion of your social security or railroad retirement benefits. Each fund may invest a portion of its assets in private activity bonds. The income from these bonds is a preference item when determining your alternative minimum tax. Exempt-interest dividends from interest earned on municipal securities of a state, or its political subdivisions, generally are exempt from that state's personal income tax. Most states, however, do not grant tax-free treatment to interest from municipal securities of other states. Distributions of ordinary income and capital gains, and gains from the sale or exchange of your fund shares generally will be subject to state and local income tax. Non-U.S. investors may be subject to U.S. withholding and estate tax. You should consult your tax advisor about the federal, state, local or foreign tax consequences of your investment in a fund. [Insert graphic of dollar bill] FINANCIAL HIGHLIGHTS The tables below present each fund's financial performance for the past five years. This information has been audited by PricewaterhouseCoopers LLP. ARIZONA FUND YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 10.77 10.36 10.36 9.80 10.28 --------------------------------- Net investment income .53 .54 .55 .55 .55 Net realized and unrealized gains (losses) .07 .42 - .57 (.48) -------------------------------- Total from investment operations .60 .96 .55 1.12 .07 -------------------------------- Distributions from net investment income (.53) (.55) (.55) (.56) (.55) -------------------------------- Net asset value, end of year 10.84 10.77 10.36 10.36 9.80 ---------------------------------- Total return (%) 1 5.75 9.53 5.55 11.64 .94 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 80,684 58,059 39,693 38,199 20,794 Ratios to average net assets: (%) Expenses .37 .30 .25 .16 .10 Expenses excluding waiver and payments by affiliate .84 .82 .86 .86 .96 Net investment income 4.87 5.11 5.45 5.51 5.80 Portfolio turnover rate (%) 10.68 17.44 18.27 4.12 44.61 1. Total return does not include sales charges. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. FLORIDA FUND YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 10.43 9.99 10.02 9.53 10.07 ---------------------------------- Net investment income .51 .53 .53 .53 .52 Net realized and unrealized gains (losses) .10 .44 (.03) .49 (.53) -------------------------------- Total from investment operations .61 .97 .50 1.02 (.01) -------------------------------- Distributions from net investment income (.51) (.53) (.53) (.53) (.53) --------------------------------- Net asset value, end of year 10.53 10.43 9.99 10.02 9.53 --------------------------------- Total return (%) 1 6.01 9.94 5.17 10.95 .21 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 124,488 101,506 77,177 69,583 46,847 Ratios to average net assets: (%) Expenses .42 .35 .35 .35 .35 Expenses excluding waiver and payments by affiliate .79 .80 .80 .82 .88 Net investment income 4.88 5.16 5.36 5.37 5.61 Portfolio turnover rate (%) 1.81 8.08 32.23 24.36 43.71 1. Total return does not include sales charges. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. INSURED FUND CLASS A YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.31 12.15 12.27 11.97 12.45 ---------------------------------- Net investment income .63 .66 .69 .71 .71 Net realized and unrealized gains (losses).06 .29 (.11) .30 (.48) --------------------------------- Total from investment operations .69 .95 .58 1.01 .23 --------------------------------- Distributions from net investment income (.63) (.66) (.70) (.71) (.71) In excess of net investment income (.01) (.01) - - - Distributions from net realized gains (.10) (.12) - - - ---------------------------------- Total distributions (.74) (.79) (.70) (.71) (.71) ---------------------------------- Net asset value, end of year 12.26 12.31 12.15 12.27 11.97 Total return (%) 2 5.72 8.09 4.88 8.66 2.03 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1 million) 1,727 1,685 1,662 1,705 1,683 Ratios to average net assets: (%) Expenses .62 .61 .60 .60 .59 Net investment income 5.11 5.44 5.68 5.81 6.00 Portfolio turnover rate (%) 13.16 27.77 18.66 13.52 14.42 CLASS C - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.38 12.21 12.31 11.98 ------------------------------ Net investment income .57 .60 .62 .54 Net realized and unrealized gains (losses).05 .29 (.09) .32 ----------------------------- Total from investment operations .62 .89 .53 .86 ----------------------------- Distributions from net investment income (.57) 3 (.60) (.63) (.53) Distributions from net realized gains (.10) (.12) - - ----------------------------- Total distributions (.67) (.72) (.63) (.53) ----------------------------- Net asset value, end of year 12.33 12.38 12.21 12.31 ------------------------------ Total return (%) 2 5.12 7.52 4.42 7.32 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 65,166 38,057 21,521 8,152 Ratios to average net assets: (%) Expenses 1.18 1.18 1.17 1.18 4 Net investment income 4.54 4.86 5.10 5.21 4 Portfolio turnover rate (%) 13.16 27.77 18.66 13.52 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Includes distributions in excess of net investment income in the amount of $.004. 4. Annualized. MASSACHUSETTS FUND CLASS A YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.75 11.54 11.65 11.34 11.81 ------------------------------------- Net investment income .59 .61 .63 .66 .66 Net realized and unrealized gains (losses).03 .35 (.10) .31 (.47) ------------------------------------ Total from investment operations .62 .96 .53 .97 .19 ------------------------------------ Distributions from net investment income (.59) (.61) (.64) 2(.66) (.66) In excess of net investment income - (.01) - - - Distributions from net realized gains (.07) (.13) - - - ------------------------------------ Total distributions (.66) (.75) (.64) (.66) (.66) ------------------------------------ Net asset value, end of year 11.71 11.75 11.54 11.65 11.34 ------------------------------------- Total return (%) 3 5.36 8.50 4.75 8.80 1.83 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 340,109 328,147 325,065 301,529 288,331 Ratios to average net assets: (%) Expenses .68 .68 .68 .69 .67 Net investment income 4.99 5.21 5.51 5.67 5.89 Portfolio turnover rate (%) 6.80 30.46 29.22 10.29 16.90 CLASS C - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.80 11.59 11.69 11.36 ---------------------------- Net investment income .52 .55 .57 .50 Net realized and unrealized gains (losses).03 .34 (.09) .32 -------------------------- Total from investment operations .55 .89 .48 .82 -------------------------- Distributions from net investment income (.52) (.55) (.58) 2(.49) Distributions from net realized gains (.07) (.13) - - --------------------------- Total distributions (.59) (.68) (.58) (.49) --------------------------- Net asset value, end of year 11.76 11.80 11.59 11.69 ---------------------------- Total return (%) 3 4.74 7.86 4.22 7.36 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 26,271 13,937 6,378 2,759 Ratios to average net assets: (%) Expenses 1.24 1.25 1.25 1.26 4 Net investment income 4.44 4.59 4.96 5.06 4 Portfolio turnover rate (%) 6.80 30.46 29.22 10.29 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.001. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. MICHIGAN FUND CLASS A YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.20 12.00 12.09 11.76 12.24 ------------------------------------- Net investment income .61 .63 .66 .68 .69 Net realized and unrealized gains (losses).13 .34 (.09) .34 (.48) ----------------------------------- Total from investment operations .74 .97 .57 1.02 .21 ----------------------------------- Distributions from net investment income (.61) (.63) (.66) 3 (.69) 2 (.69) In excess of net investment income - (.01) - - - Distributions from net realized gains (.05) (.13) - - - ----------------------------------- Total distributions (.66) (.77) (.66) (.69) (.69) ----------------------------------- Net asset value, end of year 12.28 12.20 12.00 12.09 11.76 ------------------------------------- Total return (%) 4 6.23 8.37 4.90 8.86 1.87 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1 million) 1,161 1,143 1,112 1,115 1,038 Ratios to average net assets: (%) Expenses .63 .63 .62 .62 .61 Net investment income 4.98 5.24 5.52 5.65 5.87 Portfolio turnover rate (%) 7.37 20.08 30.03 9.38 9.12 CLASS C - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.27 12.07 12.14 11.77 ----------------------------- Net investment income .55 .57 .59 .51 Net realized and unrealized gains (losses).13 .33 (.07) .37 --------------------------- Total from investment operations .68 .90 .52 .88 --------------------------- Distributions from net investment income (.54) (.57) (.59) (.51) Distributions from net realized gains (.05) (.13) - - --------------------------- Total distributions (.59) (.70) (.59) (.51) --------------------------- Net asset value, end of year 12.36 12.27 12.07 12.14 ----------------------------- Total return (%) 4 5.71 7.70 4.44 7.58 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 49,970 32,873 20,162 6,683 Ratios to average net assets: (%) Expenses 1.19 1.20 1.19 1.20 5 Net investment income 4.42 4.67 4.94 5.03 5 Portfolio turnover rate (%) 7.37 20.08 30.03 9.38 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.001. 3. Includes distributions in excess of net investment income in the amount of $.002. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Annualized. MINNESOTA FUND CLASS A YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.16 12.01 12.14 11.88 12.33 ----------------------------------- Net investment income .61 .64 .65 .67 .69 Net realized and unrealized gains (losses).01 .25 (.12) .27 (.45) ---------------------------------- Total from investment operations .62 .89 .53 .94 .24 ---------------------------------- Distributions from net investment income (.62) 3 (.64) (.66) (.68) (.69) 2 Distributions from net realized gains (.02) (.10) - - - ---------------------------------- Total distributions (.64) (.74) (.66) (.68) (.69) ---------------------------------- Net asset value, end of year 12.14 12.16 12.01 12.14 11.88 ------------------------------------ Total return (%) 4 5.18 7.60 4.54 8.06 2.12 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 515,174 495,315 482,128 492,139 479,934 Ratios to average net assets: (%) Expenses .67 .65 .66 .66 .66 Net investment income 5.01 5.29 5.47 5.58 5.81 Portfolio turnover rate (%) 16.25 14.87 14.40 17.72 17.59 CLASS C - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.21 12.05 12.17 11.89 ---------------------------- Net investment income .54 .57 .59 .50 Net realized and unrealized gains (losses).01 .26 (.12) .28 -------------------------- Total from investment operations .55 .83 .47 .78 -------------------------- Distributions from net investment income (.55) 3 (.57) (.59) (.50) Distributions from net realized gains (.02) (.10) - - -------------------------- Total distributions (.57) (.67) (.59) (.50) -------------------------- Net asset value, end of year 12.19 12.21 12.05 12.17 ---------------------------- Total return (%) 4 4.58 7.04 3.98 6.67 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 20,896 10,131 4,844 1,152 Ratios to average net assets: (%) Expenses 1.23 1.22 1.23 1.25 5 Net investment income 4.44 4.72 4.87 4.94 5 Portfolio turnover rate (%) 16.25 14.87 14.40 17.72 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions from net realized gains of $.004. 3. Includes distributions in excess of net investment income in the amount of $.001. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Annualized. OHIO FUND CLASS A YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.45 12.19 12.22 11.90 12.40 ----------------------------------- Net investment income .62 .64 .66 .68 .69 Net realized and unrealized gains (losses).07 .33 (.03) .33 (.50) ---------------------------------- Total from investment operations .69 .97 .63 1.01 .19 ---------------------------------- Distributions from net investment income (.62) (.64) 4 (.66) 3(.69) 2(.69) Distributions from net realized gains (.03) (.07) - - - ---------------------------------- Total distributions (.65) (.71) (.66) (.69) (.69) ---------------------------------- Net asset value, end of year 12.49 12.45 12.19 12.22 11.90 ------------------------------------ Total return (%) 5 5.63 8.22 5.35 8.66 1.74 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 776,592 741,079 698,360 685,783 652,545 Ratios to average net assets: (%) Expenses .65 .64 .64 .64 .63 Net investment income 4.98 5.24 5.43 5.58 5.83 Portfolio turnover rate (%) 6.56 12.84 14.95 11.47 11.76 CLASS C - ------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.51 12.24 12.26 11.90 ----------------------------- Net investment income .55 .58 .59 .52 Net realized and unrealized gains (losses).08 .34 (.02) .35 --------------------------- Total from investment operations .63 .92 .57 .87 --------------------------- Distributions from net investment income (.55) (.58) (.59) (.51) Distributions from net realized gains (.03) (.07) - - ---------------------------- Total distributions (.58) (.65) (.59) (.51) ---------------------------- Net asset value, end of year 12.56 12.51 12.24 12.26 ---------------------------- Total return (%) 5 5.10 7.66 4.79 7.43 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 42,258 28,178 15,786 6,085 Ratios to average net assets: (%) Expenses 1.21 1.20 1.20 1.22 6 Net investment income 4.42 4.67 4.80 4.99 6 Portfolio turnover rate (%) 6.56 12.84 14.95 11.47 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.001. 3. Includes distributions in excess of net investment income in the amount of $.003. 4. Includes distributions in excess of net investment income in the amount of $.007. 5. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 6. Annualized. YOUR ACCOUNT [Insert graphic of pencil marking an X] CHOOSING A SHARE CLASS Each class has its own sales charge and expense structure, allowing you to choose the class that best meets your situation. Your investment representative can help you decide. CLASS A CLASS C (ALL FUNDS EXCEPT ARIZONA AND FLORIDA) - ---------------------------------------------------------------------- o Initial sales charge of 4.25% or o Initial sales charge of 1% less o Deferred sales charge of 1% on o Deferred sales charge of 1% on purchases of $1 million or more shares you sell within 18 sold within 12 months months o Lower annual expenses than Class o Higher annual expenses than C due to lower distribution fees Class A due to higher distribution fees. BEFORE JANUARY 1, 1999, CLASS A SHARES WERE DESIGNATED CLASS I AND CLASS C SHARES WERE DESIGNATED CLASS II. SALES CHARGES - CLASS A THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT - ------------------------------------------------------------------------------- Under $100,000 4.25 4.44 $100,000 but under $250,000 3.50 3.63 $250,000 but under $500,000 2.50 2.56 $500,000 but under $1 million 2.00 2.04 INVESTMENTS OF $1 MILLION OR MORE If you invest $1 million or more, either as a lump sum or through our cumulative quantity discount or letter of intent programs (see page 29), you can buy Class A shares without an initial sales charge. However, there is a 1% contingent deferred sales charge (CDSC) on any shares you sell within 12 months of purchase. The way we calculate the CDSC is the same for each class (please see page 28). DISTRIBUTION AND SERVICE (12B-1) FEES Class A has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution fees of up to 0.15% per year for the Arizona and Florida Funds and 0.10% per year for the remaining funds, to those who sell and distribute Class A shares and provide other services to shareholders. Because these fees are paid out of Class A's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. SALES CHARGES - CLASS C THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT - ------------------------------------------------------------------------------- Under $1 million 1.00 1.01 WE PLACE ANY INVESTMENT OF $1 MILLION OR MORE IN CLASS A SHARES, SINCE THERE IS NO INITIAL SALES CHARGE AND CLASS A'S ANNUAL EXPENSES ARE LOWER. CDSC There is a 1% contingent deferred sales charge (CDSC) on any Class C shares you sell within 18 months of purchase. The way we calculate the CDSC is the same for each class (please see below). DISTRIBUTION AND SERVICE (12B-1) FEES Class C has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution and other fees of up to 0.65% per year for the sale of Class C shares and for services provided to shareholders. Because these fees are paid out of Class C's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. CONTINGENT DEFERRED SALES CHARGE (CDSC) - CLASS A & C The CDSC for each class is based on the current value of the shares being sold or their net asset value when purchased, whichever is less. There is no CDSC on shares you acquire by reinvesting your dividends or capital gains distributions. [Begin callout] The HOLDING PERIOD FOR THE CDSC begins on the day you buy your shares. Your shares will age one month on that same date the next month and each following month. For example, if you buy shares on the 18th of the month, they will age one month on the 18th day of the next month and each following month. [End callout] To keep your CDSC as low as possible, each time you place a request to sell shares we will first sell any shares in your account that are not subject to a CDSC. If there are not enough of these to meet your request, we will sell the shares in the order they were purchased. We will use this same method if you exchange your shares into another Franklin Templeton Fund (please see page 34 for exchange information). SALES CHARGE REDUCTIONS AND WAIVERS If you qualify for any of the sales charge reductions or waivers below, please let us know at the time you make your investment to help ensure you receive the lower sales charge. QUANTITY DISCOUNTS We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases of Class A shares. [Begin callout] The Franklin Templeton Funds include all of the Franklin Templeton U.S. registered mutual funds, except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. [End callout] o CUMULATIVE QUANTITY DISCOUNT - lets you combine all of your shares in the Franklin Templeton Funds for purposes of calculating the sales charge. You also may combine the shares of your spouse, and your children or grandchildren, if they are under the age of 21. Certain company and retirement plan accounts also may be included. o LETTER OF INTENT (LOI) - expresses your intent to buy a stated dollar amount of shares over a 13-month period and lets you receive the same sales charge as if all shares had been purchased at one time. We will reserve a portion of your shares to cover any additional sales charge that may apply if you do not buy the amount stated in your LOI. TO SIGN UP FOR THESE PROGRAMS, COMPLETE THE APPROPRIATE SECTION OF YOUR ACCOUNT APPLICATION. REINSTATEMENT PRIVILEGE If you sell shares of a Franklin Templeton Fund, you may reinvest some or all of the proceeds within 365 days without an initial sales charge. The proceeds must be reinvested within the same share class, except proceeds from the sale of Class B shares will be reinvested in Class A shares. If you paid a CDSC when you sold your Class A or C shares, we will credit your account with the amount of the CDSC paid but a new CDSC will apply. For Class B shares reinvested in Class A, a new CDSC will not apply, although your account will not be credited with the amount of any CDSC paid when you sold your Class B shares. Proceeds immediately placed in a Franklin Bank Certificate of Deposit (CD) also may be reinvested without an initial sales charge if you reinvest them within 365 days from the date the CD matures, including any rollover. This privilege does not apply to shares you buy and sell under our exchange program. Shares purchased with the proceeds from a money fund may be subject to a sales charge. SALES CHARGE WAIVERS Class A shares may be purchased without an initial sales charge or CDSC by various individuals and institutions or by investors who reinvest certain distributions and proceeds within 365 days. The CDSC for each class also may be waived for certain redemptions and distributions. If you would like information about available sales charge waivers, call your investment representative or call Shareholder Services at 1-800/632-2301. A list of available sales charge waivers also may be found in the Statement of Additional Information (SAI). GROUP INVESTMENT PROGRAM Allows established groups of 11 or more investors to invest as a group. For sales charge purposes, the group's investments are added together. There are certain other requirements and the group must have a purpose other than buying fund shares at a discount. [Insert graphic of paper with lines and someone writing] BUYING SHARES MINIMUM INVESTMENTS - ------------------------------------------------------------------------------- INITIAL ADDITIONAL Regular accounts $1,000 $50 UGMA/UTMA accounts $100 $50 Broker-dealer sponsored wrap account programs $250 $50 Full-time employees, officers, trustees and directors of Franklin Templeton entities, and their immediate family members $100 $50 ACCOUNT APPLICATION If you are opening a new account, please complete and sign the enclosed account application. Make sure you indicate the share class you have chosen. If you do not indicate a class, we will place your purchase in Class A shares. To save time, you can sign up now for services you may want on your account by completing the appropriate sections of the application (see the next page). BUYING SHARES - ---------------------------------------------------------------------- OPENING AN ACCOUNT ADDING TO AN ACCOUNT - ---------------------------------------------------------------------- [Insert graphic of Contact your Contact your hands shaking] THROUGH investment investment YOUR INVESTMENT representative representative REPRESENTATIVE - ---------------------------------------------------------------------- [Insert graphic of Make your check Make your check envelope] BY MAIL payable to the fund. payable to the fund. Include your account Mail the check and number on the check. your signed application to Fill out the deposit Investor Services. slip from your account statement. If you do not have a slip, include a note with your name, the fund name, and your account number. Mail the check and deposit slip or note to Investor Services. - ---------------------------------------------------------------------- [Insert graphic of Call to receive a Call to receive a three lightning bolts] wire control number wire control number BY WIRE and wire instructions. and wire instructions. 1-800/632-2301 Wire the funds and To make a same day (or 1-650/312-2000 mail your signed wire investment, collect) application to please call us by Investor Services. 1:00 p.m. pacific Please include the time and make sure wire control number your wire arrives by or your new account 3:00 p.m. number on the application. To make a same day wire investment, please call us by 1:00 p.m. pacific time and make sure your wire arrives by 3:00 p.m. - ---------------------------------------------------------------------- [Insert graphic of two Call Shareholder Call Shareholder arrows pointing in Services at the Services at the opposite directions] number below, or send number below or our BY EXCHANGE signed written automated TeleFACTS instructions. The system, or send TeleFACTS(R) TeleFACTS system signed written 1-800/247-1753 cannot be used to instructions. (around-the-clock open a new account. access) (Please see page 34 (Please see page 34 for information on for information on exchanges.) exchanges.) - ---------------------------------------------------------------------- FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151, SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of person with handset] INVESTOR SERVICES AUTOMATIC INVESTMENT PLAN This plan offers a convenient way for you to invest in a fund by automatically transferring money from your checking or savings account each month to buy shares. The minimum investment to open an account with an automatic investment plan is $50. To sign up, complete the appropriate section of your account application. AUTOMATIC PAYROLL DEDUCTION You may be able to invest automatically in Class A shares of a fund by transferring money from your paycheck to the fund by electronic funds transfer. If you are interested, indicate on your application that you would like to receive an Automatic Payroll Deduction Program kit. DISTRIBUTION OPTIONS You may reinvest distributions you receive from a fund in an existing account in the same share class* of a fund or another Franklin Templeton Fund. Initial sales charges and CDSCs will not apply if you reinvest your distributions within 365 days. You can also have your distributions deposited in a bank account, or mailed by check. Deposits to a bank account may be made by electronic funds transfer. Please indicate on your application the distribution option you have chosen, otherwise we will reinvest your distributions in the same share class of the fund. *Class C shareholders may reinvest their distributions in Class A shares of any Franklin Templeton money fund. TELEFACTS(R) Our TeleFACTS system offers around-the-clock access to information about your account or any Franklin Templeton Fund. This service is available from touch-tone phones at 1-800/247-1753. For a free TeleFACTS brochure, call 1-800/DIAL BEN. TELEPHONE PRIVILEGES You will automatically receive telephone privileges when you open your account, allowing you and your investment representative to sell or exchange your shares and make certain other changes to your account by phone. For accounts with more than one registered owner, telephone privileges also allow the funds to accept written instructions signed by only one owner for transactions and account changes that could otherwise be made by phone. For all other transactions and changes, all registered owners must sign the instructions. As long as we take certain measures to verify telephone requests, we will not be responsible for any losses that may occur from unauthorized requests. Of course, you can decline telephone exchange or redemption privileges on your account application. EXCHANGE PRIVILEGE You can exchange shares between most Franklin Templeton Funds within the same class*, generally without paying any additional sales charges. If you exchange shares held for less than six months, however, you may be charged the difference between the initial sales charge of the two funds if the difference is more than 0.25%. If you exchange shares from a money fund, a sales charge may apply no matter how long you have held the shares. [Begin callout] An EXCHANGE is really two transactions: a sale of one fund and the purchase of another. In general, the same policies that apply to purchases and sales apply to exchanges, including minimum investment amounts. Exchanges also have the same tax consequences as ordinary sales and purchases. [End callout] Generally exchanges may only be made between identically registered accounts, unless you send written instructions with a signature guarantee. Any CDSC will continue to be calculated from the date of your initial investment and will not be charged at the time of the exchange. The purchase price for determining a CDSC on exchanged shares will be the price you paid for the original shares. If you exchange shares subject to a CDSC into a Class A money fund, the time your shares are held in the money fund will not count towards the CDSC holding period. Frequent exchanges can interfere with fund management or operations and drive up costs for all shareholders. To protect shareholders, there are limits on the number and amount of exchanges you may make (please see "Market Timers" on page 38). *Certain Class Z shareholders of Franklin Mutual Series Fund Inc. may exchange into Class A without any sales charge. Advisor Class shareholders of another Franklin Templeton Fund also may exchange into Class A without any sales charge. Advisor Class shareholders who exchange their shares for Class A shares and later decide they would like to exchange into another fund that offers Advisor Class may do so. SYSTEMATIC WITHDRAWAL PLAN This plan allows you to automatically sell your shares and receive regular payments from your account. A CDSC may apply to withdrawals that exceed certain amounts. Certain terms and minimums apply. To sign up, complete the appropriate section of your application. [Insert graphic of certificate] SELLING SHARES You can sell your shares at any time. SELLING SHARES IN WRITING Generally, requests to sell $100,000 or less can be made over the phone or with a simple letter. Sometimes, however, to protect you and the fund we will need written instructions signed by all registered owners, with a signature guarantee for each owner, if: [Begin callout] A SIGNATURE GUARANTEE helps protect your account against fraud. You can obtain a signature guarantee at most banks and securities dealers. A notary public CANNOT provide a signature guarantee. [End callout] o you are selling more than $100,000 worth of shares o you want your proceeds paid to someone who is not a registered owner o you want to send your proceeds somewhere other than the address of record, or preauthorized bank or brokerage firm account We also may require a signature guarantee on instructions we receive from an agent, not the registered owners, or when we believe it would protect the fund against potential claims based on the instructions received. SELLING RECENTLY PURCHASED SHARES If you sell shares recently purchased with a check or draft, we may delay sending you the proceeds until your check or draft has cleared, which may take seven business days or more. A certified or cashier's check may clear in less time. REDEMPTION PROCEEDS Your redemption check will be sent within seven days after we receive your request in proper form. We are not able to receive or pay out cash in the form of currency. Redemption proceeds may be delayed if we have not yet received your signed account application. - ---------------------------------------------------------------------- SELLING SHARES - ---------------------------------------------------------------------- TO SELL SOME OR ALL OF YOUR SHARES - ---------------------------------------------------------------------- [Insert graphic of Contact your investment representative hands shaking] THROUGH YOUR INVESTMENT REPRESENTATIVE - ---------------------------------------------------------------------- [Insert graphic of Send written instructions and endorsed envelope] BY MAIL share certificates (if you hold share certificates) to Investor Services. Corporate, partnership or trust accounts may need to send additional documents. Specify the fund, the account number and the dollar value or number of shares you wish to sell. Be sure to include all necessary signatures and any additional documents, as well as signature guarantees if required. A check will be mailed to the name(s) and address on the account, or otherwise according to your written instructions. - ---------------------------------------------------------------------- [Insert graphic of As long as your transaction is for $100,000 phone] BY PHONE or less, you do not hold share certificates 1-800/632-2301 and you have not changed your address by phone within the last 15 days, you can sell your shares by phone. A check will be mailed to the name(s) and address on the account. Written instructions, with a signature guarantee, are required to send the check to another address or to make it payable to another person. - ---------------------------------------------------------------------- [Insert graphic of You can call or write to have redemption three lightning bolts] proceeds of $1,000 or more wired to a bank BY WIRE or escrow account. See the policies above for selling shares by mail or phone. Before requesting a bank wire, please make sure we have your bank account information on file. If we do not have this information, you will need to send written instructions with your bank's name and address, your bank account number, the ABA routing number, and a signature guarantee. Requests received in proper form by 1:00 p.m. pacific time will be wired the next business day. - ---------------------------------------------------------------------- [Insert graphic of two Obtain a current prospectus for the fund arrows pointing in you are considering. opposite directions] BY EXCHANGE Call Shareholder Services at the number below or our automated TeleFACTS system, or TeleFACTS(R) send signed written instructions. See the 1-800/247-1753 policies above for selling shares by mail (around-the-clock or phone. access) If you hold share certificates, you will need to return them to the fund before your exchange can be processed. - ---------------------------------------------------------------------- FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151, SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of paper and pen] ACCOUNT POLICIES CALCULATING SHARE PRICE Each fund calculates its net asset value per share (NAV) each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). Each class's NAV is calculated by dividing its net assets by the number of its shares outstanding. [Begin callout] When you buy shares, you pay the offering price. The offering price is the NAV plus any applicable sales charge. When you sell shares, you receive the NAV minus any applicable contingent deferred sales charge (CDSC). [End callout] Each fund's assets are generally valued at their market value. If market prices are unavailable, or if an event occurs after the close of the trading market that materially affects the values, assets may be valued at their fair value. Requests to buy and sell shares are processed at the NAV next calculated after we receive your request in proper form. ACCOUNTS WITH LOW BALANCES If the value of your account falls below $250 ($50 for employee and UGMA/UTMA accounts) because you sell some of your shares, we may mail you a notice asking you to bring the account back up to its applicable minimum investment amount. If you choose not to do so within 30 days, we may close your account and mail the proceeds to the address of record. You will not be charged a CDSC if your account is closed for this reason. STATEMENTS AND REPORTS You will receive confirmations and account statements that show your account transactions. You also will receive the funds' financial reports every six months. To reduce fund expenses, we try to identify related shareholders in a household and send only one copy of the financial reports. If you need additional copies, please call 1-800/DIAL BEN. If there is a dealer or other investment representative of record on your account, he or she also will receive confirmations, account statements and other information about your account directly from the fund. STREET OR NOMINEE ACCOUNTS You may transfer your shares from the street or nominee name account of one dealer to another, as long as both dealers have an agreement with Franklin Templeton Distributors, Inc. We will process the transfer after we receive authorization in proper form from your delivering securities dealer. JOINT ACCOUNTS Unless you specify a different registration, accounts with two or more owners are registered as "joint tenants with rights of survivorship" (shown as "Jt Ten" on your account statement). To make any ownership changes to a joint account, all owners must agree in writing, regardless of the law in your state. MARKET TIMERS The Insured Fund may restrict or refuse exchanges by market timers. If accepted, each exchange by a market timer will be charged $5 by Franklin/Templeton Investor Services, Inc., the fund's transfer agent. The remaining funds do not allow investments by market timers. You will be considered a market timer if you have (i) requested an exchange out of the fund within two weeks of an earlier exchange request, or (ii) exchanged shares out of the fund more than twice in a calendar quarter, or (iii) exchanged shares equal to at least $5 million, or more than 1% of the fund's net assets, or (iv) otherwise seem to follow a timing pattern. Shares under common ownership or control are combined for these limits. ADDITIONAL POLICIES Please note that the funds maintain additional policies and reserve certain rights, including: o The funds may refuse any order to buy shares, including any purchase under the exchange privilege. o At any time, the funds may change their investment minimums or waive or lower their minimums for certain purchases. o The funds may modify or discontinue the exchange privilege on 60 days' notice. o You may only buy shares of a fund eligible for sale in your state or jurisdiction. o In unusual circumstances, we may temporarily suspend redemptions, or postpone the payment of proceeds, as allowed by federal securities laws. o For redemptions over a certain amount, each fund reserves the right to make payments in securities or other assets of the fund, in the case of an emergency or if the payment by check or wire would be harmful to existing shareholders. o To permit investors to obtain the current price, dealers are responsible for transmitting all orders to the funds promptly. DEALER COMPENSATION Qualifying dealers who sell fund shares may receive sales commissions and other payments. These are paid by Franklin Templeton Distributors, Inc. (Distributors) from sales charges, distribution and service (12b-1) fees and its other resources. CLASS A CLASS C - ------------------------------------------------------------------------------- COMMISSION (%) - 2.00 Investment under $100,000 4.00 - $100,000 but under $250,000 3.25 - $250,000 but under $500,000 2.25 - $500,000 but under $1 million 1.85 - $1 million or more up to 0.75 1 - 12B-1 FEE TO DEALER 0.15% (Arizona and 0.65 2 Florida Funds) 0.10% (all other funds) A dealer commission of up to 0.25% may be paid on Class A NAV purchases by certain trust companies and bank trust departments, eligible governmental authorities, and broker-dealers or others on behalf of clients participating in comprehensive fee programs. 1. During the first year after purchase, dealers may not be eligible to receive the 12b-1 fee. 2. Dealers may be eligible to receive up to 0.15% during the first year after purchase and may be eligible to receive the full 12b-1 fee starting in the 13th month. [Insert graphic of question mark] QUESTIONS If you have any questions about the funds or your account, you can write to us at P.O. Box 997151, Sacramento, CA 95899-9983. You can also call us at one of the following numbers. For your protection and to help ensure we provide you with quality service, all calls may be monitored or recorded. HOURS (PACIFIC TIME, DEPARTMENT NAME TELEPHONE MONDAY THROUGH FRIDAY) NUMBER - ---------------------------------------------------------------------- Shareholder Services 1-800/632-2301 5:30 a.m. to 5:00 p.m. 6:30 a.m. to 2:30 p.m. (Saturday) Fund Information 1-800/DIAL BEN 5:30 a.m. to 8:00 p.m. (1-800/342-5236)6:30 a.m. to 2:30 p.m. (Saturday) Retirement Plan Services 1-800/527-2020 5:30 a.m. to 5:00 p.m. Dealer Services 1-800/524-4040 5:30 a.m. to 5:00 p.m. Institutional Services 1-800/321-8563 6:00 a.m. to 5:00 p.m. TDD (hearing impaired) 1-800/851-0637 5:30 a.m. to 5:00 p.m. FOR MORE INFORMATION You can learn more about each fund in the following documents: ANNUAL/SEMIANNUAL REPORT TO SHAREHOLDERS Includes a discussion of recent market conditions and fund strategies, financial statements, detailed performance information, portfolio holdings, and the auditor's report. STATEMENT OF ADDITIONAL INFORMATION (SAI) Contains more information about each fund, its investments and policies. It is incorporated by reference (is legally a part of this prospectus). For a free copy of the current annual/semiannual report or the SAI, please contact your investment representative or call us at the number below. FRANKLIN(R)TEMPLETON(R) 1-800/DIAL BEN(R) (1-800/342-5236) TDD (Hearing Impaired) 1-800/851-0637 www.franklin-templeton.com You can also obtain information about each fund by visiting the SEC's Public Reference Room in Washington D.C. (phone 1-800/SEC-0330) or by sending your request and a duplicating fee to the SEC's Public Reference Section, Washington, DC 20549-6009. You can also visit the SEC's Internet site at http://www.sec.gov. Investment Company Act file #811-4149 TF1 P 07/99 Prospectus FRANKLIN TAX-FREE TRUST INVESTMENT STRATEGY TAX-FREE INCOME Franklin Alabama Tax-Free Income Fund Franklin Florida Tax-Free Income Fund Franklin Georgia Tax-Free Income Fund Franklin Kentucky Tax-Free Income Fund Franklin Louisiana Tax-Free Income Fund Franklin Maryland Tax-Free Income Fund Franklin Missouri Tax-Free Income Fund Franklin North Carolina Tax-Free Income Fund Franklin Texas Tax-Free Income Fund Franklin Virginia Tax-Free Income Fund July 1, 1999 [Insert Franklin Templeton Ben Head] The SEC has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. CONTENTS THE FUNDS [Begin callout] INFORMATION ABOUT EACH FUND YOU SHOULD KNOW BEFORE INVESTING [End callout] 2 Goals and Strategies 4 Main Risks 7 Performance 17 Fees and Expenses 20 Management 23 Distributions and Taxes 25 Financial Highlights YOUR ACCOUNT [Begin callout] INFORMATION ABOUT SALES CHARGES, ACCOUNT TRANSACTIONS AND SERVICES [End callout] 35 Choosing a Share Class 38 Buying Shares 40 Investor Services 42 Selling Shares 44 Account Policies 47 Questions FOR MORE INFORMATION [Begin callout] WHERE TO LEARN MORE ABOUT EACH FUND [End callout] Back Cover THE FUNDS [Insert graphic of bullseye and arrows] GOALS AND STRATEGIES GOALS Each fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. Each fund also tries to provide a maximum level of income exempt from personal income taxes, if any, for resident shareholders of the fund's state. PRINCIPAL INVESTMENTS Each fund normally invests predominately in municipal securities whose interest is free from federal income taxes, including the federal alternative minimum tax, and the personal income taxes, if any, of the fund's state. Although each fund tries to invest all of its assets in tax-free securities, it is possible, although not anticipated, that up to 20% of its assets may be in securities that pay taxable interest. [Begin callout] MUNICIPAL SECURITIES are issued by state and local governments, their agencies and authorities, as well as by the District of Columbia and U.S. territories and possessions, to borrow money for various public and private projects. The issuer pays a fixed, floating or variable rate of interest, and must repay the amount borrowed (the "principal") at maturity. [End callout] Each fund only buys securities rated in the top four ratings by U.S. nationally recognized rating services (or comparable unrated securities). The manager selects securities that it believes will provide the best balance between risk and return within a fund's range of allowable investments and typically uses a buy and hold strategy. This means it holds securities in the fund's portfolio for income purposes, rather than trading securities for capital gains, although the manager may sell a security at any time if it believes it could help the fund meet its goal. Each fund also may invest in municipal lease obligations, which generally are issued to finance the purchase of public property. The property is leased to a state or local government and the lease payments are used to pay the interest on the obligations. These differ from other municipal securities because the money to make the lease payments must be set aside each year or the lease can be cancelled without penalty. If this happens, investors who own the obligations may not be paid. TEMPORARY INVESTMENTS The manager may take a temporary defensive position when it believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist. Under these circumstances, a fund may be unable to pursue its investment goals, because it may not invest or may invest substantially less in tax-free securities or in municipal securities of the fund's state. [Insert graphic of chart with line going up and down] MAIN RISKS INCOME Since the fund can only distribute what it earns, the fund's distributions to shareholders may decline when interest rates fall. CREDIT There is the possibility that an issuer will be unable to make interest payments and repay principal. Changes in an issuer's financial strength or in a security's credit rating may affect a security's value and, thus, impact fund performance. Many of each fund's portfolio securities may be supported by credit enhancements, which may be provided by either U.S. or foreign entities. These securities have the credit risk of the entity providing the credit support. To the extent a fund holds insured securities, a change in the credit rating of any one or more of the municipal bond insurers that insure securities in the fund's portfolio may affect the value of the securities they insure, the fund's share price and fund performance. Credit support provided by a foreign entity may be less certain because of the possibility of adverse foreign economic, political or legal developments that may affect the ability of that entity to meet its obligations. [Begin callout] Because interest rates and municipal security prices fluctuate, the amount of the fund's distributions, the fund's yield, and the value of your investment in the fund will go up and down. This means you could lose money over short or even extended periods. [End callout] INTEREST RATE When interest rates go up, municipal security prices fall. The opposite is also true: municipal security prices go up when interest rates fall. In general, securities with longer maturities are more sensitive to these price changes. CALL There is the likelihood that a security will be prepaid (called) before maturity. An issuer is more likely to call its securities when interest rates are falling, because the issuer can issue new securities with lower interest payments. If a security is called, the fund may have to replace it with a lower-yielding security. At any time, each fund may have a large amount of its assets invested in municipal securities subject to call risk, including escrow-secured or defeased bonds. A call of some or all of these securities may lower the fund's income and yield and its distributions to shareholders. MARKET A security's value may be reduced by market activity or the results of supply and demand. This is a basic risk associated with all securities. When there are more sellers than buyers, prices tend to fall. Likewise, when there are more buyers than sellers, prices tend to go up. Each fund may invest more than 25% of its assets in municipal securities that finance similar types of projects, such as hospitals, housing, industrial development, transportation or pollution control. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects, thereby increasing market risk. WHEN-ISSUED AND DELAYED DELIVERY TRANSACTIONS Municipal securities may be issued on a when-issued or delayed delivery basis, where payment and delivery take place at a future date. Since the market price of the security may fluctuate during the time before payment and delivery, the fund assumes the risk that the value of the security at delivery may be more or less than the purchase price. DIVERSIFICATION The Maryland Fund is a non-diversified fund. It may invest a greater portion of its assets in the municipal securities of one issuer than a diversified fund. This fund may be more sensitive to economic, business, political or other changes affecting similar issuers or securities, which may result in greater fluctuation in the value of its shares. The fund, however, intends to meet certain tax diversification requirements. The other funds are all diversified funds. Each fund may involve more risk than an investment in a fund that does not focus on securities of a single state. STATE Since each fund invests heavily in municipal securities of its state, events in that state are likely to affect the fund's investments and its performance. These events may include economic or political policy changes, tax base erosion, state constitutional limits on tax increases, budget deficits and other financial difficulties, and changes in the credit ratings assigned to the state's municipal issuers. A negative change in any one of these or other areas could affect the ability of a state's municipal issuers to meet their obligations. It is important to remember that economic, budget and other conditions within a state are unpredictable and can change at any time. U.S. TERRITORIES Each fund may invest up to 35% of its assets in municipal securities issued by U.S. territories. As with state municipal securities, events in any of these territories where a fund is invested may affect the fund's investments and its performance. YEAR 2000 When evaluating current and potential portfolio positions, Year 2000 is one of the factors the funds' manager considers. Municipal issuers generally are not required to report on their Year 2000 readiness. This makes it more difficult for the manager to evaluate their readiness. There have been reports, however, that many municipal issuers are behind in their efforts to address the Year 2000 problem. The manager, of course, cannot audit each issuer and its major suppliers to verify their Year 2000 readiness. The manager is making efforts, however, to contact the issuers of municipal securities held by the funds to try to assess their Year 2000 readiness. If an issuer in which the fund is invested is adversely affected by Year 2000 problems, it is possible that the issuer's ability to make timely interest and principal payments also will be affected, at least temporarily. This may affect both the amount and timing of the fund's distributions and the fund's performance. It also is likely that the price of the issuer's securities will be adversely affected. A decrease in the value of one or more of the fund's portfolio holdings will have a similar impact on the fund's performance. Please see page 21 for more information. More detailed information about the funds, their policies (including temporary investments), risks and municipal securities ratings can be found in the funds' Statement of Additional Information (SAI). [Begin callout] Mutual fund shares are not deposits or obligations of, or guaranteed or endorsed by, any bank, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency of the U.S. government. Mutual fund shares involve investment risks, including the possible loss of principal. [End callout] [Insert graphic of a bull and a bear] PERFORMANCE The bar charts and tables below show the volatility of each fund's returns, which is one indicator of the risks of investing in a fund. The bar charts show changes in each fund's returns from year to year over the calendar years shown. The tables show how each fund's average annual total returns compare to those of a broad-based securities market index. Of course, past performance cannot predict or guarantee future results. ALABAMA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.85% 5.29 12.40% 8.79% 12.24% -4.44% 15.28% 4.95% 9.03% 3.42% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 6.25% WORST QUARTER: Q1 '94 - -4.36% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Alabama Fund - Class A 2 -0.96% 4.54% 7.08% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) Alabama Fund - Class C 0.84% 6.15% Lehman Brothers Municipal Bond Index3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.00% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. FLORIDA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.82% 6.08% 12.56% 8.81% 12.01% -3.34% 14.67% 4.39% 8.11% 6.34% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 5.93% WORST QUARTER: Q1 '94 - -3.84% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ------------------------------------------------------------------------------ Florida Fund - Class A 2 1.79% 4.96% 7.37% Lehman Brothers Municipal Bond Index3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) Florida Fund - Class C 3.66% 6.57% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.73% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. GEORGIA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] [Begin callout] BEST QUARTER: Q2 '89 6.23% WORST QUARTER: Q1 '94 - -4.26% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Georgia Fund - Class A 2 1.13% 4.62% 7.19% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------- Georgia Fund - Class C 2 3.01% 6.21% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.63% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. KENTUCKY FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.48% 13.90% -8.52% 19.86% 4.26% 9.35% 6.09% 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 8.79% WORST QUARTER: Q1 '94 - -7.34% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 SINCE INCEPTION 1 YEAR 5 YEARS (10/12/91) - ----------------------------------------------------------------------------- Kentucky Fund - Class A 2 1.56% 4.89% 7.03% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 7.65% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.73%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, the fund implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. LOUISIANA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.68% 6.50% 12.23% 8.98% 11.13% -4.80% 14.59% 4.83% 8.79% 5.39% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q2 '89 5.93% WORST QUARTER: Q1 '94 - -4.47% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Louisiana Fund - Class A 2 0.88% 4.66% 7.24% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - ---------------------------------------------------------------------------- Louisiana Fund - Class C 2 2.71% 6.57% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.81% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MARYLAND FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.78% 5.41% 12.06% 8.87% 12.15% -5.09% 17.27% 3.96% 8.54% 5.88% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 7.25% WORST QUARTER: Q1 '94 - -4.78% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Maryland Fund - Class A 2 1.36% 4.96% 7.26% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Maryland Income Fund - Class C 2 3.20% 6.82% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.73% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MISSOURI FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.74% 6.66% 11.97% 9.02% 13.28% -5.09% 15.68% 4.70% 9.14% 5.76% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 6.44% WORST QUARTER: Q1 '94 - -4.84% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Missouri Fund - Class A 2 1.27% 4.91% 7.48% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Missouri Fund - Class C 2 3.13% 6.76% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.88% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. NORTH CAROLINA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.29% 6.33% 11.50% 9.12% 11.67% -5.73% 16.12% 4.08% 8.91% 5.94% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 7.28% WORST Quarter: Q1 '94 - -4.97% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- North Carolina Fund - Class A 2 1.42% 4.71% 7.20% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------- North Carolina Fund - Class C 2 3.48% 6.64% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.70% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. TEXAS FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.51% 6.04% 12.14% 8.56% 11.59% -2.79% 13.32% 5.17% 9.10% 5.10% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q2 '89 5.56% WORST QUARTER: Q1 '94 - -3.48% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Texas Fund - Class A 2 0.63% 4.92% 7.31% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------- Texas Fund - Class C 2 2.51% 6.78% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.80% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. VIRGINIA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.06% 5.91% 12.53% 8.95% 12.40% -4.64% 15.45% 4.17% 8.50% 5.83% 89 90 91 92 93 94 95 96 97 98 [Begin callout] BEST QUARTER: Q1 '95 6.53% WORST QUARTER: Q1 '94 - -4.30% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- Virginia Fund - Class A 2 1.30% 4.75% 7.32% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) Virginia Fund - Class C 2 3.25% 6.55% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.77% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. [Insert graphic of percentage sign] FEES AND EXPENSES This table describes the fees and expenses that you may pay if you buy and hold shares of a fund. SHAREHOLDER FEES (FEES PAID DIRECTLY FROM YOUR INVESTMENT) ALABAMA FLORIDA GEORGIA KENTUCKY LOUISIANA FUND FUND FUND FUND FUND - ---------------------------------------------------------------------------- CLASS A 1 Maximum sales charge (load) as a percentage of offering price 4.25% 4.25% 4.25% 4.25% 4.25% Load imposed on purchases 4.25% 4.25% 4.25% 4.25% 4.25% Maximum deferred sales charge (load) 2 None None None None None Exchange fee None None None None None Class C 1 Maximum sales charge (load) as a percentage of offering price 1.99% 1.99% 1.99% - 1.99% Load imposed on purchases 1.00% 1.00% 1.00% - 1.00% Maximum deferred sales charge (load) 3 0.99% 0.99% 0.99% - 0.99% Exchange fee None None None - None NORTH MARYLAND MISSOURI CAROLINA TEXAS VIRGINIA FUND FUND FUND FUND FUND - ------------------------------------------------------------------------------ CLASS A 1 Maximum sales charge (load) as a percentage of offering price 4.25% 4.25% 4.25% 4.25% 4.25% Load imposed on purchases 4.25% 4.25% 4.25% 4.25% 4.25% Maximum deferred sales charge (load) 2 None None None None None Exchange fee None None None None None Class C 1 Maximum sales charge (load) as a percentage of offering price 1.99% 1.99% 1.99% 1.99% 1.99% Load imposed on purchases 1.00% 1.00% 1.00% 1.00% 1.00% Maximum deferred sales charge (load) 3 0.99% 0.99% 0.99% 0.99% 0.99% Exchange fee None None None None None Please see "Choosing a Share Class" on page 35 for an explanation of how and when these sales charges apply. ANNUAL FUND OPERATING EXPENSES (EXPENSES DEDUCTED FROM FUND ASSETS) ALABAMA FLORIDA GEORGIA KENTUCKY LOUISIANA FUND FUND FUND FUND FUND - ------------------------------------------------------------------------------- CLASS A 1 Management fees 0.56% 0.47% 0.58% 0.63%4 0.59% Distribution and service (12b-1) fees 5 0.09% 0.09% 0.10% 0.10% 0.09% Other expenses 0.06% 0.05% 0.08% 0.08% 0.07% --------------------------------- Total annual fund operating expenses 0.71% 0.61% 0.76% 0.81%4 0.75% =================================== CLASS C 1 Management fees 0.56% 0.47% 0.58% - 0.59% Distribution and service (12b-1) fees5 0.65% 0.65% 0.65% - 0.65% Other expenses 0.06% 0.05% 0.08% - 0.07% ---------------------------------- Total annual fund operating expenses 1.27% 1.17% 1.31% - 1.31% ================================== NORTH MARYLAND MISSOURI CAROLINA TEXAS VIRGINIA FUND FUND FUND FUND FUND - -------------------------------------------------------------------------- CLASS A 1 Management fees 0.55% 0.53% 0.53% 0.59% 0.52% Distribution and service (12b-1 ) fees 5 0.10% 0.10% 0.10% 0.09% 0.09% Other expenses 0.09% 0.07% 0.07% 0.09% 0.07% -------------------------------- Total annual fund operating expenses 0.74% 0.70% 0.70% 0.77% 0.68% =============================== CLASS C 1 Management fees 0.55% 0.53% 0.53% 0.59% 0.52% Distribution and service (12b-1) fees 5 0.65% 0.65% 0.65% 0.65% 0.65% Other expenses 0.09% 0.07% 0.07% 0.09% 0.07% -------------------------------- Total annual fund operating expenses 1.29% 1.25% 1.25% 1.33% 1.24% ================================ 1. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. 2. Except for investments of $1 million or more (see page 35). 3. This is equivalent to a charge of 1% based on net asset value. 4. For the fiscal year ended February 28, 1999, the manager had agreed in advance to limit its management fees. With this reduction, management fees were 0.24% and total annual fund operating expenses were 0.42%. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. 5. Because of the distribution and service (12b-1) fees, over the long term you may indirectly pay more than the equivalent of the maximum permitted initial sales charge. EXAMPLE This example can help you compare the cost of investing in a fund with the cost of investing in other mutual funds. The example assumes you invest $10,000 for the periods shown and then sell all of your shares at the end of those periods. The example also assumes your investment has a 5% return each year and the fund's operating expenses remain the same. Although your actual costs may be higher or lower, based on these assumptions your costs would be: ALABAMA FLORIDA GEORGIA KENTUCKY LOUISIANA FUND FUND FUND FUND FUND - ------------------------------------------------------------------------------- CLASS A 1 Year 1 $494 $485 $499 $504 $498 3 Years $642 $612 $658 $673 $654 5 Years $803 $751 $829 $856 $824 10 Years $1,270 $1,155 $1,327 $1,384 $1,316 CLASS C 1 Year 2 $326 $316 $330 - $330 3 Years $499 $468 $511 - $511 5 Years $790 $737 $811 - $811 10 Years $1,619 $1,506 $1,663 - $1,663 NORTH MARYLAND MISSOURI CAROLINA TEXAS VIRGINIA FUND FUND FUND FUND FUND - ------------------------------------------------------------------------------ CLASS A 1 Year 1 $497 $493 $493 $500 $492 3 Years $651 $639 $639 $661 $633 5 Years $819 $798 $798 $835 $788 10 Years $1,304 $1,259 $1,259 $1,339 $1,236 CLASS C 1 Year 2 $328 $324 $324 $332 $323 3 Years $505 $493 $493 $517 $489 5 Years $800 $779 $779 $821 $774 10 Years $1,641 $1,596 $1,596 $1,685 $1,585 1. Assumes a contingent deferred sales charge (CDSC) will not apply. 2. For the same Class C investment, your costs would be $228 for the Alabama Fund, $218 for the Florida Fund, $232 for the Georgia Fund, $232 for the Louisiana Fund, $230 for the Maryland Fund, $226 for the Missouri Fund, $226 for the North Carolina Fund, $234 for the Texas Fund and $225 for the Virginia Fund if you did not sell your shares at the end of the first year. Your costs for the remaining periods would be the same. [Insert graphic of briefcase] MANAGEMENT Franklin Advisers, Inc. (Advisers), 777 Mariners Island Blvd., San Mateo, CA 94404, is each fund's investment manager. Together, Advisers and its affiliates manage over $227 billion in assets. The team responsible for the funds' management is: THOMAS KENNY, EXECUTIVE VICE PRESIDENT OF ADVISERS Mr. Kenny has been an analyst or portfolio manager of each fund since its inception. He is the Director of Franklin's Municipal Bond Department. He joined the Franklin Templeton Group in 1986. SHEILA AMOROSO, SENIOR VICE PRESIDENT OF ADVISERS Ms. Amoroso has been an analyst or portfolio manager of the Florida and Missouri Funds since their inception. She joined the Franklin Templeton Group in 1986. BEN BARBER, VICE PRESIDENT OF ADVISERS Mr. Barber has been an analyst or portfolio manager of the Alabama and Missouri Funds since 1993. He joined the Franklin Templeton Group in 1991. MARK ORSI, VICE PRESIDENT OF ADVISERS Mr. Orsi has been an analyst or portfolio manager of the Kentucky, North Carolina and Virginia Funds since 1991. He joined the Franklin Templeton Group in 1990. JOHN POMEROY, VICE PRESIDENT OF ADVISERS Mr. Pomeroy has been an analyst or portfolio manager of the Alabama, Georgia and Maryland Funds since 1989. He joined the Franklin Templeton Group in 1986. FRANCISCO RIVERA, PORTFOLIO MANAGER OF ADVISERS Mr. Rivera has been an analyst or portfolio manager of the Georgia, Kentucky, Louisiana and Texas Funds since 1996. He joined the Franklin Templeton Group in 1994. JOHN WILEY, VICE PRESIDENT OF ADVISERS Mr. Wiley has been an analyst or portfolio manager of the Louisiana and Texas Funds since 1991. He joined the Franklin Templeton Group in 1989. STELLA WONG, VICE PRESIDENT OF ADVISERS Ms. Wong has been an analyst or portfolio manager of the Florida, Maryland, North Carolina and Virginia Funds since their inception. She joined the Franklin Templeton Group in 1986. Each fund pays the manager a fee for managing the fund's assets and making its investment decisions. For the fiscal year ended February 28, 1999, the funds paid the following management fees to the manager: MANAGEMENT FEES - ------------------------------------------------------------------------------ Alabama Fund 0.56% Florida Fund 0.47% Georgia Fund 0.58% Kentucky Fund 0.24% 1 Louisiana Fund 0.59% Maryland Fund 0.55% Missouri Fund 0.53% North Carolina Fund 0.53% Texas Fund 0.59% Virginia Fund 0.52% 1. Management fees, before any advance waiver, were 0.63%. Under an agreement by the manager to limit its fees, the fund paid the management fees shown. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. YEAR 2000 PROBLEM Each fund's business operations depend on a worldwide network of computer systems that contain date fields, including securities trading systems, securities transfer agent operations and stock market links. Many of the systems currently use a two digit date field to represent the date, and unless these systems are changed or modified, they may not be able to distinguish the Year 1900 from the Year 2000 (commonly referred to as the Year 2000 problem). In addition, the fact that the Year 2000 is a leap year may create difficulties for some systems. When the Year 2000 arrives, the funds' operations could be adversely affected if the computer systems used by the manager, its service providers and other third parties it does business with are not Year 2000 ready. For example, the funds' portfolio and operational areas could be impacted, including securities trade processing, interest and dividend payments, securities pricing, shareholder account services, reporting, custody functions and others. The funds' manager and its affiliated service providers are making a concerted effort to take steps they believe are reasonably designed to address their Year 2000 problems. Of course, the funds' ability to reduce the effects of the Year 2000 problem is also very much dependent upon the efforts of third parties over which the funds and their manager may have no control. [Insert graphic of dollar signs and stacks of coins] DISTRIBUTIONS AND TAXES INCOME AND CAPITAL GAINS DISTRIBUTIONS Each fund declares dividends daily from its net investment income and pays them monthly on or about the 20th day of the month. Your account may begin to receive dividends on the day after we receive your investment and will continue to receive dividends through the day we receive a request to sell your shares. Capital gains, if any, may be distributed twice a year. The amount of these distributions will vary and there is no guarantee the fund will pay dividends. Please keep in mind that if you invest in a fund shortly before the fund deducts a capital gain distribution from its net asset value, you will receive some of your investment back in the form of a taxable distribution. TAX CONSIDERATIONS Fund distributions will consist primarily of exempt-interest dividends from interest earned on municipal securities. In general, exempt-interest dividends are exempt from federal income tax. Each fund, however, may invest a portion of its assets in securities that pay income that is not tax-exempt. Fund distributions from such income are taxable to you as ordinary income. Any capital gains a fund distributes are taxable to you as long-term capital gains no matter how long you have owned your shares. Distributions of ordinary income or capital gains are taxable whether you reinvest your distributions in additional fund shares or receive them in cash. [Begin callout] BACKUP WITHHOLDING By law, a fund must withhold 31% of your taxable distributions and proceeds if you do not provide your correct social security or taxpayer identification number, or if the IRS instructs a fund to do so. [End callout] Every January, you will receive a statement that shows the tax status of distributions you received for the previous year. Distributions declared in December but paid in January are taxable as if they were paid in December. When you sell your shares of a fund, you may have a capital gain or loss. For tax purposes, an exchange of your fund shares for shares of a different Franklin Templeton Fund is the same as a sale. The individual tax rate on any gain from the sale or exchange of your shares depends on how long you have held your shares. Exempt-interest dividends are taken into account when determining the taxable portion of your social security or railroad retirement benefits. Each fund may invest a portion of its assets in private activity bonds. The income from these bonds is a preference item when determining your alternative minimum tax. Exempt-interest dividends from interest earned on municipal securities of a state, or its political subdivisions, generally are exempt from that state's personal income tax. Most states, however, do not grant tax-free treatment to interest from municipal securities of other states. Distributions of ordinary income and capital gains, and gains from the sale or exchange of your fund shares generally will be subject to state and local income tax. Non-U.S. investors may be subject to U.S. withholding and estate tax. You should consult your tax advisor about the federal, state, local or foreign tax consequences of your investment in a fund. [Insert graphic of a dollar bill] FINANCIAL HIGHLIGHTS This table presents each fund's financial performance for the past five years. This information has been audited by PricewaterhouseCoopers LLP. ALABAMA FUND CLASS A YEAR ENDED FEBRUARY 28, 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.98 11.73 11.73 11.31 11.80 ----------------------------- Net investment income .62 .64 .65 .66 .66 Net realized and unrealized gains (losses) (.25) .36 .01 .42 (.50) ---------------------------- Total from investment operations .37 1.00 .66 1.08 .16 --------------------------- Distributions from net investment income (.62)2 (.65) (.66) (.66) (.65) ----------------------------- Distributions from net realized gains (.05) (.10) - - - ----------------------------- Total distributions (.67) (.75) (.66) (.66) (.65) ----------------------------- Net asset value, end of year 11.68 11.98 11.73 11.73 11.31 ============================== Total return (%) 3 3.21 8.79 5.84 9.74 1.54 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 238,670 216,982 193,466 185,981 170,051 Ratios to average net assets: (%) Expenses .71 .72 .71 .72 .72 Net investment income 5.23 5.39 5.62 5.69 5.88 Portfolio turnover rate (%) 8.67 10.44 15.47 12.39 19.85 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 12.04 11.78 11.77 11.36 ----------------------- Net investment income .56 .58 .59 .49 Net realized and unrealized gains (losses) (.25) .36 .01 .41 ---------------------- Total from investment operations .31 .94 .60 .90 --------------------- Distributions from net investment income (.56) 2 (.58) (.59)(.49) ------------------------- Distributions from net realized gains (.05) (.10) - - ------------------------ Total distributions (.61) (.68) (.59) (.49) ----------------------- Net asset value, end of year 11.74 12.04 11.78 11.77 ======================= Total return (%)3 2.62 8.23 5.28 8.01 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 14,895 9,469 5,683 1,662 Ratios to average net assets: (%) Expenses 1.27 1.29 1.28 1.29 4 Net investment income 4.67 4.80 5.05 5.09 4 Portfolio turnover rate (%) 8.67 10.44 15.47 12.39 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.006 and $.004 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. FLORIDA FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.87 11.59 11.69 11.35 11.77 ----------------------------- Net investment income .62 .64 .67 .69 .69 Net realized and unrealized gains (losses) .05 .30 (.08) .34 (.44) ---------------------------- Total from investment operations .67 .94 .59 1.03 .25 ---------------------------- Distributions from net investment income (.62) 2 (.65)(.69)(.69)(.67) ---------------------------- Distributions from net realized gains (.01) (.01) - - - ---------------------------- Total distributions (.63) (.66) (.69) (.69) (.67) ---------------------------- Net asset value, end of year 11.91 11.87 11.59 11.69 11.35 ============================= Total return (%)3 5.75 8.37 5.20 9.28 2.36 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1 million) 1,786 1,650 1,458 1,354 1,265 Ratios to average net assets: (%) Expenses .61 .61 .60 .60 .59 Net investment income 5.19 5.45 5.78 5.93 6.15 Portfolio turnover rate (%) 7.66 5.60 12.00 11.78 14.34 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.96 11.67 11.76 11.37 ----------------------- Net investment income .55 .60 .60 .52 Net realized and unrealized gains (losses) .06 .29 (.07) .38 ----------------------- Total from investment operations .61 .89 .53 .90 ----------------------- Distributions from net investment income (.55)2 (.59) (.62)(.51) Distributions from net realized gains (.01) (.01) - - ----------------------- Total distributions (.56) (.60) (.62)(.51) ----------------------- Net asset value, end of year 12.01 11.96 11.67 11.76 ======================== Total return (%)3 5.21 7.80 4.65 8.05 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 82,596 56,027 23,556 7,644 Ratios to average net assets: (%) Expenses 1.17 1.17 1.17 1.18 4 Net investment income 4.63 4.88 5.17 5.33 4 Portfolio turnover rate (%) 7.66 5.60 12.00 11.78 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.0005 and $.0004 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. GEORGIA FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.12 11.86 11.88 11.54 12.00 ----------------------------- Net investment income .61 .63 .65 .66 .66 Net realized and unrealized gains (losses) .01 .27 (.02) .34 (.46) ------------------------------ Total from investment operations .62 .90 .63 1.00 .20 ------------------------------ Distributions from net investment income (.61)2 (.64)3(.65) (.66) (.66) Distributions from net realized gains (.06) - - - - ------------------------------- Total distributions (.67) (.64) (.65) (.66) (.66) ----------------------------- Net asset value, end of year 12.07 12.12 11.86 11.88 11.54 ============================= Total return (%)4 5.22 7.75 5.47 8.90 1.87 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 164,669 149,642 139,903 130,380 116,771 Ratios to average net assets: (%) Expenses .76 .76 .75 .77 .76 Net investment income 5.00 5.28 5.49 5.58 5.76 Portfolio turnover rate (%) 12.84 14.77 17.47 10.98 36.17 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 12.19 11.92 11.92 11.57 ----------------------- Net investment income .54 .57 .58 .50 Net realized and unrealized gains (losses) .02 .27 (.01) .34 ----------------------- Total from investment operations .56 .84 .57 .84 ----------------------- Distributions from net investment income (.54)2 (.57)(.57) (.49) Distributions from net realized gains (.06) - - - ----------------------- Total distributions (.60) (.57) (.57) (.49) Net asset value, end of year 12.15 12.19 11.92 11.92 ======================= Total return (%)4 4.70 7.19 4.97 7.40 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 17,277 9,107 4,484 1,335 Ratios to average net assets: (%) Expenses 1.31 1.32 1.32 1.34 5 Net investment income 4.45 4.72 4.87 5.04 5 Portfolio turnover rate (%) 12.84 14.77 17.47 10.98 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.004 and $.003 for Class A and C, respectively. 3. Includes distributions in excess of net investment income in the amount of $.001. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Annualized. KENTUCKY FUND YEAR ENDED FEBRUARY 28, - --------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - --------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.45 11.05 11.04 10.54 11.18 ----------------------------- Net investment income .59 .61 .61 .62 .61 Net realized and unrealized gains (losses) .03 .40 .01 .50 (.62) ----------------------------- Total from investment operations .62 1.01 .62 1.12 (.01) ----------------------------- Distributions from net investment income (.60 1(.61) (.61) (.62) (.63) ------------------------------- Net asset value, end of year 11.47 11.45 11.05 11.04 10.54 ============================= Total return (%)2 5.51 9.38 5.86 10.73 .11 Ratios/supplemental data Net assets, end of year ($ x 1,000) 64,516 54,211 44,289 38,991 32,831 Ratios to average net assets: (%) Expenses .42 .35 .34 .33 .29 Expenses excluding waiver and payments by affiliate .81 .81 .81 .82 .80 Net investment income 5.12 5.40 5.63 5.65 5.94 Portfolio turnover rate (%) 10.49 26.61 24.81 31.89 32.92 1. Includes distribution in excess of net investment income in the amount of $.004. 2. Total return does not include sales charges. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. LOUISIANA FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ----------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.61 11.32 11.32 11.03 11.56 ------------------------------ Net investment income .60 .63 .65 .66 .66 Net realized and unrealized gains (losses) (.01) .30 - .28 (.55) ------------------------------ Total from investment operations .59 .93 .65 .94 .11 --------------------------- Distributions from net investment income (.61)2 (.64) (.65)(.65) (.64) ----------------------------- Net asset value, end of year 11.59 11.61 11.32 11.32 11.03 ============================= Total return (%)3 5.23 8.46 5.94 8.75 1.14 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 158,099 134,922 112,981 107,461 104,980 Ratios to average net assets: (%) Expenses .75 .76 .76 .78 .75 Net investment income 5.14 5.50 5.76 5.89 5.98 Portfolio turnover rate (%) 14.99 15.26 13.68 5.23 32.28 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.68 11.37 11.37 11.01 ----------------------- Net investment income .54 .57 .58 .49 Net realized and unrealized gains (losses) (.01) .32 - .35 ----------------------- Total from investment operations .53 .89 .58 .84 ----------------------- Distributions from net investment income (.55)2 (.58)(.58) (.48) ------------------------ Net asset value, end of year 11.66 11.68 11.37 11.37 ======================= Total return (%)3 4.61 8.02 5.27 7.76 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 9,982 4,469 3,004 1,438 Ratios to average net assets: (%) Expenses 1.31 1.32 1.33 1.35 4 Net investment income 4.58 4.95 5.29 5.27 4 Portfolio turnover rate (%) 14.99 15.26 13.68 5.23 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.0006 and $.0004 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. MARYLAND FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.64 11.33 11.38 10.92 11.36 ----------------------------- Net investment income .58 .59 .61 .62 .63 Net realized and unrealized gains (losses) .06 .32 (.03) .47 (.45) ---------------------------- Total from investment operations .64 .91 .58 1.09 .18 --------------------------- Distributions from net investment income (.58)2 (.60)3 (.63)(.63)(.62) ---------------------------- Distributions from net realized gains (.04) - - - - ---------------------------- Total distributions (.62) (.60) (.63) (.63) (.62) ----------------------------- Net asset value, end of year 11.66 11.64 11.33 11.38 10.92 ============================= Total return (%)4 5.64 8.27 5.24 10.18 1.78 Ratios/supplemental data Net assets, end of year ($ x 1,000) 253,014 213,005 185,234 175,078 153,145 Ratios to average net assets: (%) Expenses .74 .74 .73 .74 .73 Net investment income 4.91 5.20 5.42 5.56 5.86 Portfolio turnover rate (%) 6.02 3.19 12.71 8.11 20.30 Class C Per share data ($) Net asset value, beginning of year 11.72 11.40 11.44 10.93 ----------------------- Net investment income .51 .54 .55 .47 Net realized and unrealized gains (losses) .07 .31 (.03) .51 ----------------------- Total from investment operations .58 .85 .52 .98 ----------------------- Distributions from net investment income (.51)2 (.53)(.56)(.47) Distributions from net realized gains (.04) - - - ----------------------- Total distributions (.55) (.53) (.56) (.47) ----------------------- Net asset value, end of year 11.75 11.72 11.40 11.44 ======================= Total return (%)4 5.11 7.70 4.68 9.06 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 16,826 10,515 5,084 913 Ratios to average net assets: (%) Expenses 1.29 1.30 1.27 1.31 5 Net investment income 4.35 4.63 4.78 4.95 5 Portfolio turnover rate (%) 6.02 3.19 12.71 8.11 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.004 and $.003 for Class A and C, respectively. 3. Includes distributions in excess of net investment income in the amount of $.005. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Annualized. MISSOURI FUND CLASS A YEAR ENDED FEBRUARY 28, - ---------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.23 11.83 11.94 11.44 11.94 ----------------------------- Net investment income .61 .64 .65 .65 .65 Net realized and unrealized gains (losses) - .44 (.07) .49 (.50) ---------------------------- Total from investment operations .61 1.08 .58 1.14 .15 --------------------------- Distributions from net investment income (.62) (.64) (.65) (.64) (.65) Distributions from net realized gains (.03) (.04) (.04) - - --------------------------- Total distributions (.65) (.68) (.69) (.64) (.65) ----------------------------- Net asset value, end of year 12.19 12.23 11.83 11.94 11.44 ============================= Total return (%)2 5.12 9.43 5.06 10.23 1.44 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 386,948 308,045 269,564 247,522 227,442 Ratios to average net assets: (%) Expenses .70 .71 .70 .71 .70 Net investment income 4.99 5.32 5.56 5.58 5.75 Portfolio turnover rate (%) 15.21 14.30 21.81 18.27 19.84 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 12.27 11.85 11.97 11.47 ----------------------- Net investment income .54 .58 .57 .48 Net realized and unrealized gains (losses) .01 .45 (.07) .50 ---------------------- Total from investment operations .55 1.03 .50 .98 ---------------------- Distributions from net investment income (.55) (.57) (.58) (.48) Distributions from net realized gains (.03) (.04) (.04) - ---------------------- Total distributions (.58) (.61) (.62) (.48) ----------------------- Net asset value, end of year 12.24 12.27 11.85 11.97 ======================= Total return (%)2 4.58 8.96 4.32 8.66 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 20,396 10,045 4,295 1,325 Ratios to average net assets: (%) Expenses 1.25 1.27 1.27 1.27 3 Net investment income 4.44 4.75 4.92 4.94 3 Portfolio turnover rate (%) 15.21 14.30 21.81 18.27 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Annualized. NORTH CAROLINA FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.11 11.73 11.75 11.37 11.92 ----------------------------- Net investment income .60 .62 .64 .64 .65 Net realized and unrealized gains (losses .06 .38 (.03) .39 (.55) ----------------------------- Total from investment operations .66 1.00 .61 1.03 .10 ----------------------------- Distributions from net investment income (.61) (.62) (.63) (.65)2 (.65) ------------------------------- Net asset value, end of year 12.16 12.11 11.73 11.75 11.37 ============================= Total return (%)3 5.54 8.78 5.38 9.28 1.06 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 349,419 297,406 260,979 247,031 216,263 Ratios to average net assets: (%) Expenses .70 .70 .70 .71 .70 Net investment income 4.95 5.24 5.47 5.52 5.75 Portfolio turnover rate (%) 5.44 9.95 9.98 25.19 25.05 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 12.18 11.79 11.80 11.41 ----------------------- Net investment income .54 .56 .57 .49 Net realized and unrealized gains (losses) .06 .39 (.02) .38 ----------------------- Total from investment operations .60 .95 .55 .87 ----------------------- Distributions from net investment income (.54) (.56) (.56) (.48) ----------------------- Net asset value, end of year 12.24 12.18 11.79 11.80 ======================= Total return (%)3 5.02 8.22 4.83 7.77 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 38,171 20,043 9,607 2,430 Ratios to average net assets: (%) Expenses 1.25 1.26 1.26 1.28 4 Net investment income 4.40 4.69 4.85 4.90 4 Portfolio turnover rate (%) 5.44 9.95 9.98 25.19 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.001. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. TEXAS FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ----------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.68 11.37 11.58 11.25 11.72 ----------------------------- Net investment income .60 .62 .66 .67 .68 Net realized and unrealized gains (losses) (.05) .36 - .34 (.49) ----------------------------- Total from investment operations .55 .98 .66 1.01 .19 ----------------------------- Distributions from net investment income (.60)2 (.63) (.67) (.68) (.66) In excess of net investment income - (.01) - - - Distributions from net realized gains (.21) (.03) (.20) - - ----------------------------- Total distributions (.81) (.67) (.87) (.68) (.66) ----------------------------- Net asset value, end of year 11.42 11.68 11.37 11.58 11.25 ============================= Total return (%)3 4.86 8.91 5.91 9.15 1.80 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 127,739 130,578 126,612 129,702 130,684 Ratios to average net assets: (%) Expenses .77 .76 .75 .76 .73 Net investment income 5.17 5.44 5.70 5.86 6.05 Portfolio turnover rate (%) 25.26 34.52 35.57 18.38 6.36 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.81 11.49 11.68 11.27 ----------------------- Net investment income .53 .58 .60 .51 Net realized and unrealized gains (losses) (.03) .35 .02 .40 ----------------------- Total from investment operations .50 .93 .62 .91 ----------------------- Distributions from net investment income (.53)2 (.58)4(.61)(.50) Distributions from net realized gains (.21) (.03) (.20 - ------------------------ Total distributions (.74) (.61) (.81) (.50) ----------------------- Net asset value, end of year 11.57 11.81 11.49 11.68 ======================= Total return (%)3 4.40 8.31 5.48 8.23 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 5,229 2,076 740 79 Ratios to average net assets: (%) Expenses 1.33 1.33 1.32 1.33 5 Net investment income 4.61 4.79 5.03 5.23 5 Portfolio turnover rate (%) 25.26 34.52 35.57 18.38 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.0005 and $.0003 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Includes distributions in excess of net investment income in the amount of $.001. 5. Annualized. VIRGINIA FUND CLASS A YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - ---------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.88 11.65 11.72 11.33 11.82 ----------------------------- Net investment income .60 .62 .65 .66 .66 Net realized and unrealized gains (losses) .03 .35 (.07) .38 (.50) ---------------------------- Total from investment operations .63 .97 .58 1.04 .16 --------------------------- Distributions from net investment income (.60)2 (.64) (.64)(.65) (.65) Distributions from net realized gains (.03) (.10) (.01) - - --------------------------- Total distributions (.63) (.74) (.65) (.65) (.65) ----------------------------- Net asset value, end of year 11.88 11.88 11.65 11.72 11.33 ============================= Total return (%)3 5.40 8.53 5.15 9.41 1.56 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 379,670 332,199 287,172 271,396 255,965 Ratios to average net assets: (%) Expenses .68 .69 .69 .69 .69 Net investment income 4.98 5.29 5.56 5.66 5.86 Portfolio turnover rate (%) 8.90 12.90 19.25 12.72 21.73 CLASS C - ------------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.95 11.71 11.77 11.35 ----------------------- Net investment income .53 .57 .58 .49 Net realized and unrealized gains (losses) .03 .34 (.05) .41 ------------------------ Total from investment operations .56 .91 .53 .90 ------------------------ Distributions from net investment income (.53)2 (.57)(.58) (.48) Distributions from net realized gains (.03) (.10) (.01) - ------------------------ Total distributions (.56) (.67) (.59) (.48) ----------------------- Net asset value, end of year 11.95 11.95 11.71 11.77 ======================= Total return (%)3 4.78 7.97 4.61 8.07 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 22,796 13,186 6,674 2,050 Ratios to average net assets: (%) Expenses 1.24 1.25 1.25 1.26 4 Net investment income 4.42 4.72 4.94 5.06 4 Portfolio turnover rate (%) 8.90 12.90 19.25 12.72 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.0005 and $.0004 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. YOUR ACCOUNT [Insert graphic of pencil marking an "X"] CHOOSING A SHARE CLASS Each class has its own sales charge and expense structure, allowing you to choose the class that best meets your situation. Your investment representative can help you decide. CLASS A CLASS C (ALL FUNDS EXCEPT KENTUCKY) - -------------------------------------------------------------------------------- o Initial sales charge of 4.25% or o Initial sales charge of 1% less o Deferred sales charge of 1% on o Deferred sales charge of 1% on purchases of $1 million or more shares you sell within 18 months sold within 12 months o Lower annual expenses than Class C o Higher annual expenses than Class A due to lower distribution fees due to higher distribution fees. BEFORE JANUARY 1, 1999, CLASS A SHARES WERE DESIGNATED CLASS I AND CLASS C SHARES WERE DESIGNATED CLASS II. SALES CHARGES - CLASS A THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT Under $100,000 4.25 4.44 $100,000 but under $250,000 3.50 3.63 $250,000 but under $500,000 2.50 2.56 $500,000 but under $1 million 2.00 2.04 INVESTMENTS OF $1 MILLION OR MORE If you invest $1 million or more, either as a lump sum or through our cumulative quantity discount or letter of intent programs (see page 37), you can buy Class A shares without an initial sales charge. However, there is a 1% contingent deferred sales charge (CDSC) on any shares you sell within 12 months of purchase. The way we calculate the CDSC is the same for each class (please see page 36). DISTRIBUTION AND SERVICE (12B-1) FEES Class A has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows each fund to pay distribution fees of up to 0.10% per year to those who sell and distribute Class A shares and provide other services to shareholders. Because these fees are paid out of Class A's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. SALES CHARGES - CLASS C THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT Under $1 million 1.00 1.01 WE PLACE ANY INVESTMENT OF $1 MILLION OR MORE IN CLASS A SHARES, SINCE THERE IS NO INITIAL SALES CHARGE AND CLASS A'S ANNUAL EXPENSES ARE LOWER. CDSC There is a 1% contingent deferred sales charge (CDSC) on any Class C shares you sell within 18 months of purchase. The way we calculate the CDSC is the same for each class (please see below). DISTRIBUTION AND SERVICE (12B-1) FEES Class C has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution and other fees of up to 0.65% per year for the sale of Class C shares and for services provided to shareholders. Because these fees are paid out of Class C's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. CONTINGENT DEFERRED SALES CHARGE (CDSC) - CLASS A & C The CDSC for each class is based on the current value of the shares being sold or their net asset value when purchased, whichever is less. There is no CDSC on shares you acquire by reinvesting your dividends or capital gains distributions. [Begin callout] The HOLDING PERIOD FOR THE CDSC begins on the day you buy your shares. Your shares will age one month on that same date the next month and each following month. For example, if you buy shares on the 18th of the month, they will age one month on the 18th day of the next month and each following month. [End callout] To keep your CDSC as low as possible, each time you place a request to sell shares we will first sell any shares in your account that are not subject to a CDSC. If there are not enough of these to meet your request, we will sell the shares in the order they were purchased. We will use this same method if you exchange your shares into another Franklin Templeton Fund (please see page 41 for exchange information). SALES CHARGE REDUCTIONS AND WAIVERS If you qualify for any of the sales charge reductions or waivers below, please let us know at the time you make your investment to help ensure you receive the lower sales charge. QUANTITY DISCOUNTS We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases of Class A shares. [Begin callout] The FRANKLIN TEMPLETON FUNDS include all of the Franklin Templeton U.S. registered mutual funds, except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. [End callout] o CUMULATIVE QUANTITY DISCOUNT - lets you combine all of your shares in the Franklin Templeton Funds for purposes of calculating the sales charge. You also may combine the shares of your spouse, and your children or grandchildren, if they are under the age of 21. Certain company and retirement plan accounts also may be included. o LETTER OF INTENT (LOI) - expresses your intent to buy a stated dollar amount of shares over a 13-month period and lets you receive the same sales charge as if all shares had been purchased at one time. We will reserve a portion of your shares to cover any additional sales charge that may apply if you do not buy the amount stated in your LOI. TO SIGN UP FOR THESE PROGRAMS, COMPLETE THE APPROPRIATE SECTION OF YOUR ACCOUNT APPLICATION. REINSTATEMENT PRIVILEGE If you sell shares of a Franklin Templeton Fund, you may reinvest some or all of the proceeds within 365 days without an initial sales charge. The proceeds must be reinvested within the same share class, except proceeds from the sale of Class B shares will be reinvested in Class A shares. If you paid a CDSC when you sold your Class A or C shares, we will credit your account with the amount of the CDSC paid but a new CDSC will apply. For Class B shares reinvested in Class A, a new CDSC will not apply, although your account will not be credited with the amount of any CDSC paid when you sold your Class B shares. Proceeds immediately placed in a Franklin Bank Certificate of Deposit (CD) also may be reinvested without an initial sales charge if you reinvest them within 365 days from the date the CD matures, including any rollover. This privilege does not apply to shares you buy and sell under our exchange program. Shares purchased with the proceeds from a money fund may be subject to a sales charge. SALES CHARGE WAIVERS Class A shares may be purchased without an initial sales charge or CDSC by various individuals and institutions or by investors who reinvest certain distributions and proceeds within 365 days. The CDSC for each class also may be waived for certain redemptions and distributions. If you would like information about available sales charge waivers, call your investment representative or call Shareholder Services at 1-800/632-2301. A list of available sales charge waivers also may be found in the Statement of Additional Information (SAI). GROUP INVESTMENT PROGRAM Allows established groups of 11 or more investors to invest as a group. For sales charge purposes, the group's investments are added together. There are certain other requirements and the group must have a purpose other than buying fund shares at a discount. [Insert graphic of a paper with lines and someone writing] BUYING SHARES MINIMUM INVESTMENTS - ------------------------------------------------------------------------------ INITIAL ADDITIONAL - ------------------------------------------------------------------------------ REGULAR ACCOUNTS $1,000 $50 - ------------------------------------------------------------------------------ UGMA/UTMA ACCOUNTS $100 $50 - ------------------------------------------------------------------------------ Broker-dealer sponsored wrap account programs $250 $50 - ------------------------------------------------------------------------------- Full-time employees, officers, trustees and directors of Franklin Templeton entities, and their immediate family members $100 $50 - ------------------------------------------------------------------------------- ACCOUNT APPLICATION If you are opening a new account, please complete and sign the enclosed account application. Make sure you indicate the share class you have chosen. If you do not indicate a class, we will place your purchase in Class A shares. To save time, you can sign up now for services you may want on your account by completing the appropriate sections of the application (see the next page). BUYING SHARES - ------------------------------------------------------------------------------ Opening an account Adding to an account [Insert graphic of hands shaking] Contact your investment Contact your investment THROUGH YOUR INVESTMENT representative representative REPRESENTATIVE - ------------------------------------------------------------------------------ Make your check payable Make your check payable [Insert graphic of the fund. to the fund. Include envelope] your account number on Mail the check and your the check. BY MAIL signed application to Investor Services. Fill out the deposit slip from your account statement. If you do not have a slip, include a note with your name, the fund name, and your account number. Mail the check and deposit slip or note to Investor Services. [Insert graphic of Call to receive a wire Call to receive a wire three lightning bolts] control number and wire control number and wire instructions. instructions. - ------------------------------------------------------------------------------ Wire the funds and mail To make a same day wire BY WIRE your signed application to investment, please call Investor Services. Please us by 1:00 p.m. pacific 1-800/632-2301 include the wire control time and make sure your (or 1-650/312-2000 number or your new account wire arrives by 3:00 collect) number on the application. p.m. To make a same day wire Call to receive a investment, please call us wire control number by 1:00 p.m. pacific time and wire instructions. and make sure your wire arrives by 3:00 p.m. [Insert graphic of two Call Shareholder Services at Call Shareholder arrows pointing in the number below, or send Services at the number opposite directions] signed written instructions. below or our automated The TeleFACTS system cannot TeleFACTS system, or be used to open a new send signed written account. instructions. - ------------------------------------------------------------------------------ BY EXCHANGE TeleFACTS(R) (Please see page 41 for (Please see page 41 for 1-800/247-1753 information on exchanges.) information on (around-the-clock exchanges.) access). FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151 SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of person with a headset] INVESTOR SERVICES AUTOMATIC INVESTMENT PLAN This plan offers a convenient way for you to invest in a fund by automatically transferring money from your checking or savings account each month to buy shares. The minimum investment to open an account with an automatic investment plan is $50. To sign up, complete the appropriate section of your account application. AUTOMATIC PAYROLL DEDUCTION You may be able to invest automatically in Class A shares of a fund by transferring money from your paycheck to the fund by electronic funds transfer. If you are interested, indicate on your application that you would like to receive an Automatic Payroll Deduction Program kit. DISTRIBUTION OPTIONS You may reinvest distributions you receive from a fund in an existing account in the same share class* of the fund or another Franklin Templeton Fund. Initial sales charges and CDSCs will not apply if you reinvest your distributions within 365 days. You can also have your distributions deposited in a bank account, or mailed by check. Deposits to a bank account may be made by electronic funds transfer. Please indicate on your application the distribution option you have chosen, otherwise we will reinvest your distributions in the same share class of the fund. *Class C shareholders may reinvest their distributions in Class A shares of any Franklin Templeton money fund. TELEFACTS(R) Our TeleFACTS system offers around-the-clock access to information about your account or any Franklin Templeton Fund. This service is available from touch-tone phones at 1-800/247-1753. For a free TeleFACTS brochure, call 1-800/DIAL BEN. TELEPHONE PRIVILEGES You will automatically receive telephone privileges when you open your account, allowing you and your investment representative to sell or exchange your shares and make certain other changes to your account by phone. For accounts with more than one registered owner, telephone privileges also allow the funds to accept written instructions signed by only one owner for transactions and account changes that could otherwise be made by phone. For all other transactions and changes, all registered owners must sign the instructions. As long as we take certain measures to verify telephone requests, we will not be responsible for any losses that may occur from unauthorized requests. Of course, you can decline telephone exchange or redemption privileges on your account application. EXCHANGE PRIVILEGE You can exchange shares between most Franklin Templeton Funds within the same class*, generally without paying any additional sales charges. If you exchange shares held for less than six months, however, you may be charged the difference between the initial sales charge of the two funds if the difference is more than 0.25%. If you exchange shares from a money fund, a sales charge may apply no matter how long you have held the shares. [Begin callout] An EXCHANGE is really two transactions: a sale of one fund and the purchase of another. In general, the same policies that apply to purchases and sales apply to exchanges, including minimum investment amounts. Exchanges also have the same tax consequences as ordinary sales and purchases. [End callout] Generally exchanges may only be made between identically registered accounts, unless you send written instructions with a signature guarantee. Any CDSC will continue to be calculated from the date of your initial investment and will not be charged at the time of the exchange. The purchase price for determining a CDSC on exchanged shares will be the price you paid for the original shares. If you exchange shares subject to a CDSC into a Class A money fund, the time your shares are held in the money fund will not count towards the CDSC holding period. Frequent exchanges can interfere with fund management or operations and drive up costs for all shareholders. To protect shareholders, there are limits on the number and amount of exchanges you may make (please see "Market Timers" on page 45). Franklin Mutual Series Fund Inc. *Certain Class Z shareholders of may exchange into Class A without any sales charge. Advisor Class shareholders of another Franklin Templeton Fund also may exchange into Class A without any sales charge. Advisor Class shareholders who exchange their shares for Class A shares and later decide they would like to exchange into another fund that offers Advisor Class may do so. SYSTEMATIC WITHDRAWAL PLAN This plan allows you to automatically sell your shares and receive regular payments from your account. A CDSC may apply to withdrawals that exceed certain amounts. Certain terms and minimums apply. To sign up, complete the appropriate section of your application. [Insert graphic of a certificate] SELLING SHARES You can sell your shares at any time. SELLING SHARES IN WRITING Generally, requests to sell $100,000 or less can be made over the phone or with a simple letter. Sometimes, however, to protect you and the fund we will need written instructions signed by all registered owners, with a signature guarantee for each owner, if: [Begin callout] A SIGNATURE GUARANTEE helps protect your account against fraud. You can obtain a signature guarantee at most banks and securities dealers. A notary public CANNOT provide a signature guarantee. [End callout] o you are selling more than $100,000 worth of shares o you want your proceeds paid to someone who is not a registered owner o you want to send your proceeds somewhere other than the address of record, or preauthorized bank or brokerage firm account We also may require a signature guarantee on instructions we receive from an agent, not the registered owners, or when we believe it would protect the fund against potential claims based on the instructions received. SELLING RECENTLY PURCHASED SHARES If you sell shares recently purchased with a check or draft, we may delay sending you the proceeds until your check or draft has cleared, which may take seven business days or more. A certified or cashier's check may clear in less time. REDEMPTION PROCEEDS Your redemption check will be sent within seven days after we receive your request in proper form. We are not able to receive or pay out cash in the form of currency. Redemption proceeds may be delayed if we have not yet received your signed account application. SELLING SHARES - ------------------------------------------------------------------------------ TO SELL SOME OR ALL OF YOUR SHARES - ------------------------------------------------------------------------------ [Insert graphic of hands shaking] Contact your investment representative THROUGH YOUR INVESTMENT REPRESENTATIVE - ------------------------------------------------------------------------------ [Insert graphic of Send written instructions and endorsed envelope] share certificates (if you hold share certificates) to Investor BY MAIL Services. Corporate, partnership or trust accounts may need to send additional documents. Specify the fund, the account number and the dollar value or number of shares you wish to sell. Be sure to include all necessary signatures and any additional documents, as well as signature guarantees if required. A check will be mailed to the name(s) and address on the account, or otherwise according to your written instructions. - ------------------------------------------------------------------------------ [Insert graphic of As long as your transaction is for $100,000 or phone] less, you do not hold share certificates and you have not changed your address by phone BY PHONE within the last 15 days, you can sell your shares by phone. 1-800/632-2301 A check will be mailed to the name(s) and address on the account. Written instructions, with a signature guarantee, are required to send the check to another address or to make it payable to another person. - ------------------------------------------------------------------------------ [Insert graphic of three You can call or write to have redemption lightning bolts] proceeds of $1,000 or more wired to a bank or escrow account. See the policies above for selling shares by mail or phone. BY WIRE Before requesting a bank wire, please make sure we have your bank account information on file. If we do not have this information, you will need to send written instructions with your bank's name and address, your bank account number, the ABA routing number, and a signature guarantee. Requests received in proper form by 1:00 p.m. pacific time will be wired the next business day. - ------------------------------------------------------------------------------ [Insert graphic of two Obtain a current prospectus for the fund arrows pointing in opposite you are considering. directions] Call Shareholder Services at the BY EXCHANGE number below or our automated TeleFACTS system, or send signed TeleFACTS(R) written instructions. See the 1-800/247-1753 policies above for selling shares (around-the-clock access) by mail or phone. If you hold share certificates, you will need to return them to the fund before your exchange can be processed. - ------------------------------------------------------------------------------ FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151 SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of paper and pen] ACCOUNT POLICIES CALCULATING SHARE PRICE Each fund calculates its net asset value per share (NAV) each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). Each class's NAV is calculated by dividing its net assets by the number of its shares outstanding. [Begin callout] When you buy shares, you pay the offering price. The offering price is the NAV plus any applicable sales charge. When you sell shares, you receive the NAV minus any applicable contingent deferred sales charge (CDSC). [End callout] Each fund's assets are generally valued at their market value. If market prices are unavailable, or if an event occurs after the close of the trading market that materially affects the values, assets may be valued at their fair value. Requests to buy and sell shares are processed at the NAV next calculated after we receive your request in proper form. ACCOUNTS WITH LOW BALANCES If the value of your account falls below $250 ($50 for employee and UGMA/UTMA accounts) because you sell some of your shares, we may mail you a notice asking you to bring the account back up to its applicable minimum investment amount. If you choose not to do so within 30 days, we may close your account and mail the proceeds to the address of record. You will not be charged a CDSC if your account is closed for this reason. STATEMENTS AND REPORTS You will receive confirmations and account statements that show your account transactions. You also will receive the funds' financial reports every six months. To reduce fund expenses, we try to identify related shareholders in a household and send only one copy of the financial reports. If you need additional copies, please call 1-800/DIAL BEN. If there is a dealer or other investment representative of record on your account, he or she also will receive confirmations, account statements and other information about your account directly from the fund. STREET OR NOMINEE ACCOUNTS You may transfer your shares from the street or nominee name account of one dealer to another, as long as both dealers have an agreement with Franklin Templeton Distributors, Inc. We will process the transfer after we receive authorization in proper form from your delivering securities dealer. JOINT ACCOUNTS Unless you specify a different registration, accounts with two or more owners are registered as "joint tenants with rights of survivorship" (shown as "Jt Ten" on your account statement). To make any ownership changes to a joint account, all owners must agree in writing, regardless of the law in your state. MARKET TIMERS The funds do not allow investments by market timers. You will be considered a market timer if you have (i) requested an exchange out of the fund within two weeks of an earlier exchange request, or (ii) exchanged shares out of the fund more than twice in a calendar quarter, or (iii) exchanged shares equal to at least $5 million, or more than 1% of the fund's net assets, or (iv) otherwise seem to follow a timing pattern. Shares under common ownership or control are combined for these limits. ADDITIONAL POLICIES Please note that the funds maintain additional policies and reserve certain rights, including: o The funds may refuse any order to buy shares, including any purchase under the exchange privilege. o At any time, the funds may change their investment minimums or waive or lower their minimums for certain purchases. o The funds may modify or discontinue the exchange privilege on 60 days' notice. o You may only buy shares of a fund eligible for sale in your state or jurisdiction. o In unusual circumstances, we may temporarily suspend redemptions, or postpone the payment of proceeds, as allowed by federal securities laws. o For redemptions over a certain amount, each fund reserves the right to make payments in securities or other assets of the fund, in the case of an emergency or if the payment by check or wire would be harmful to existing shareholders. o To permit investors to obtain the current price, dealers are responsible for transmitting all orders to the funds promptly. DEALER COMPENSATION Qualifying dealers who sell fund shares may receive sales commissions and other payments. These are paid by Franklin Templeton Distributors, Inc. (Distributors) from sales charges, distribution and service (12b-1) fees and its other resources. CLASS A CLASS C COMMISSION (%) - 2.00 Investment under $100,000 4.00 - $100,000 but under $250,000 3.25 - $250,000 but under $500,000 2.25 - $500,000 but under $1 million 1.85 - $1 million or more up to 0.75 1 - 12B-1 FEE TO DEALER 0.10 0.65 2 A dealer commission of up to 0.25% may be paid on Class A NAV purchases by certain trust companies and bank trust departments, eligible governmental authorities, and broker-dealers or others on behalf of clients participating in comprehensive fee programs. 1. During the first year after purchase, dealers may not be eligible to receive the 12b-1 fee. 2. Dealers may be eligible to receive up to 0.15% during the first year after purchase and may be eligible to receive the full 12b-1 fee starting in the 13th month. [Insert graphic of question mark] QUESTIONS If you have any questions about the funds or your account, you can write to us at P.O. Box 997151, Sacramento, CA 95899-9983. You can also call us at one of the following numbers. For your protection and to help ensure we provide you with quality service, all calls may be monitored or recorded. HOURS (PACIFIC TIME, DEPARTMENT NAME TELEPHONE NUMBER MONDAY THROUGH FRIDAY) - ------------------------------------------------------------------------------ Shareholder Services 1-800/632-2301 5:30 a.m. to 5:00 p.m. 6:30 a.m. to 2:30 p.m. (Saturday) Fund Information 1-800/DIAL BEN 5:30 a.m. to 8:00 p.m. (1-800/342-5236) 6:30 a.m. to 2:30 p.m. (Saturday) Retirement Plan Services 1-800/527-2020 5:30 a.m. to 5:00 p.m. Dealer Services 1-800/524-4040 5:30 a.m. to 5:00 p.m. Institutional Services 1-800/321-8563 6:00 a.m. to 5:00 p.m. TDD (hearing impaired) 1-800/851-0637 5:30 a.m. to 5:00 p.m. FOR MORE INFORMATION You can learn more about each fund in the following documents: ANNUAL/SEMIANNUAL REPORT TO SHAREHOLDERS Includes a discussion of recent market conditions and fund strategies, financial statements, detailed performance information, portfolio holdings, and the auditor's report. STATEMENT OF ADDITIONAL INFORMATION (SAI) Contains more information about each fund, its investments and policies. It is incorporated by reference (is legally a part of this prospectus). For a free copy of the current annual/semiannual report or the SAI, please contact your investment representative or call us at the number below. FRANKLIN(R)TEMPLETON(R) 1-800/DIAL BEN(R) (1-800/342-5236) TDD (Hearing Impaired) 1-800/851-0637 www.franklin-templeton.com You can also obtain information about each fund by visiting the SEC's Public Reference Room in Washington D.C. (phone 1-800/SEC-0330) or by sending your request and a duplicating fee to the SEC's Public Reference Section, Washington, DC 20549-6009. You can also visit the SEC's Internet site at http://www.sec.gov. Investment Company Act file #811-4149 TF2 P 07/99 Prospectus FRANKLIN TAX-FREE TRUST INVESTMENT STRATEGY TAX-FREE INCOME Franklin Arizona Tax-Free Income Fund Franklin Colorado Tax-Free Income Fund Franklin Connecticut Tax-Free Income Fund Franklin Federal Intermediate Tax-Free Income Fund Franklin High Yield Tax-Free Income Fund Franklin Indiana Tax-Free Income Fund Franklin Michigan Tax-Free Income Fund Franklin New Jersey Tax-Free Income Fund Franklin Oregon Tax-Free Income Fund Franklin Pennsylvania Tax-Free Income Fund Franklin Puerto Rico Tax-Free Income Fund July 1, 1999 [Insert Franklin Templeton Ben Head] The SEC has not approved or disapproved these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. CONTENTS THE FUNDS [Begin callout] INFORMATION ABOUT EACH FUND YOU SHOULD KNOW BEFORE INVESTING [End callout] 2 Goals and Strategies 5 Main Risks 9 Performance 20 Fees and Expenses 26 Management 29 Distributions and Taxes 31 Financial Highlights YOUR ACCOUNT [Begin callout] INFORMATION ABOUT SALES CHARGES, ACCOUNT TRANSACTIONS AND SERVICES [End callout] 43 Choosing a Share Class 48 Buying Shares 50 Investor Services 53 Selling Shares 55 Account Policies 58 Questions FOR MORE INFORMATION [Begin callout] WHERE TO LEARN MORE ABOUT EACH FUND [End callout] Back Cover THE FUNDS [Insert graphic of bullseye and arrows] GOALS AND STRATEGIES GOALS The Federal Intermediate Fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes, including the individual alternative minimum tax, as is consistent with prudent investing, while seeking preservation of shareholders' capital. The High Yield Fund's principal investment goal is to provide investors with a high current yield exempt from federal income taxes. Its secondary goal is capital appreciation to the extent possible and consistent with the fund's principal investment goal. The Puerto Rico Fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. The Puerto Rico Fund also seeks to provide a maximum level of income that is free from the personal income taxes of a majority of states, although this policy is not a fundamental investment goal of the fund and may be changed without shareholder approval. Each state fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes and from personal income taxes for resident shareholders of the fund's state as is consistent with prudent investing, while seeking preservation of shareholders' capital. PRINCIPAL INVESTMENTS Each fund normally invests predominately in municipal securities whose interest is free from federal income taxes, including the federal alternative minimum tax, and, in the case of each state fund, the personal income taxes, if any, of the fund's state. The Puerto Rico Fund also normally invests predominately in municipal securities whose interest is free from the personal income taxes of a majority of states. Although each fund tries to invest all of its assets in tax-free securities, it is possible, although not anticipated, that up to 20% of its assets may be in securities that pay taxable interest. [Begin callout] MUNICIPAL SECURITIES are issued by state and local governments, their agencies and authorities, as well as by the District of Columbia and U.S. territories and possessions, to borrow money for various public and private projects. The issuer pays a fixed, floating or variable rate of interest, and must repay the amount borrowed (the "principal") at maturity. [End callout] Each fund, except the High Yield Fund, only buys securities rated in the top four ratings by U.S. nationally recognized rating services (or comparable unrated securities). The High Yield Fund may invest in securities rated in any rating, including defaulted securities, although it currently invests primarily in securities rated BBB/Baa or below (or comparable unrated securities). None of the funds have restrictions on the maturity of the securities they may buy, although the Federal Intermediate Fund seeks to maintain a dollar-weighted average portfolio maturity of three to 10 years. The manager selects securities that it believes will provide the best balance between risk and return within a fund's range of allowable investments and typically uses a buy and hold strategy. This means it holds securities in the fund's portfolio for income purposes, rather than trading securities for capital gains, although the manager may sell a security at any time if it believes it could help the fund meet its goal. The manager may consider existing market conditions, the availability of lower-rated securities, and whether the difference in yields between higher- and lower-rated securities justifies the higher risk of lower-rated securities when selecting securities for the High Yield Fund's portfolio. Each fund also may invest in municipal lease obligations, which generally are issued to finance the purchase of public property. The property is leased to a state or local government and the lease payments are used to pay the interest on the obligations. These differ from other municipal securities because the money to make the lease payments must be set aside each year or the lease can be cancelled without penalty. If this happens, investors who own the obligations may not be paid. TEMPORARY INVESTMENTS The manager may take a temporary defensive position when it believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist. Under these circumstances, a fund may be unable to pursue its investment goals, because it may not invest or may invest substantially less in tax-free securities or, in the case of the state and Puerto Rico Funds, in municipal securities of the fund's state or territory. [Insert graphic of chart with line going up and down] MAIN RISKS INCOME Since each fund can only distribute what it earns, the fund's distributions to shareholders may decline when interest rates fall. CREDIT There is the possibility that an issuer will be unable to make interest payments and repay principal. Changes in an issuer's financial strength or in a security's credit rating may affect a security's value and, thus, impact fund performance. Many of each fund's portfolio securities may be supported by credit enhancements, which may be provided by either U.S. or foreign entities. These securities have the credit risk of the entity providing the credit support. To the extent a fund holds insured securities, a change in the credit rating of any one or more of the municipal bond insurers that insure securities in the fund's portfolio may affect the value of the securities they insure, the fund's share price and fund performance. Credit support provided by a foreign entity may be less certain because of the possibility of adverse foreign economic, political or legal developments that may affect the ability of that entity to meet its obligations. LOWER-RATED SECURITIES. Securities rated below the top four ratings, generally have more credit risk than higher-rated securities. The High Yield Fund may invest up to 100% of its assets in lower-rated securities. None of the other funds invests in securities rated below the top four ratings. The risk of default or price changes due to changes in the issuer's credit quality is greater with lower-rated securities. Issuers of lower-rated securities are typically in weaker financial health than issuers of higher-rated securities, and their ability to make interest payments or repay principal is less certain. These issuers also are more likely to encounter financial difficulties and to be materially affected by these difficulties when they encounter them. The market price of lower-rated securities may fluctuate more than higher-rated securities and may decline significantly in periods of general or regional economic difficulty. Lower-rated securities also may be less liquid than higher-rated securities. [Begin callout] Because interest rates and municipal security prices fluctuate, the amount of the fund's distributions, the fund's yield, and the value of your investment in the fund will go up and down. This means you could lose money over short or even extended periods. [End callout] INTEREST RATE When interest rates go up, municipal security prices fall. The opposite is also true: municipal security prices go up when interest rates fall. In general, securities with longer maturities are more sensitive to these price changes. CALL There is the likelihood that a security will be prepaid (called) before maturity. An issuer is more likely to call its securities when interest rates are falling, because the issuer can issue new securities with lower interest payments. If a security is called, the fund may have to replace it with a lower-yielding security. At any time, each fund may have a large amount of its assets invested in municipal securities subject to call risk, including escrow-secured or defeased bonds. A call of some or all of these securities may lower the fund's income and yield and its distributions to shareholders. MARKET A security's value may be reduced by market activity or the results of supply and demand. This is a basic risk associated with all securities. When there are more sellers than buyers, prices tend to fall. Likewise, when there are more buyers than sellers, prices tend to go up. Each fund may invest more than 25% of its assets in municipal securities that finance similar types of projects, such as hospitals, housing, industrial development, transportation or pollution control. A change that affects one project, such as proposed legislation on the financing of the project, a shortage of the materials needed for the project, or a declining need for the project, would likely affect all similar projects, thereby increasing market risk. WHEN-ISSUED AND DELAYED DELIVERY TRANSACTIONS Municipal securities may be issued on a when-issued or delayed delivery basis, where payment and delivery take place at a future date. Since the market price of the security may fluctuate during the time before payment and delivery, the fund assumes the risk that the value of the security at delivery may be more or less than the purchase price. DIVERSIFICATION The Connecticut, Federal Intermediate and Michigan Funds are non-diversified funds. They may invest a greater portion of their assets in the municipal securities of one issuer than a diversified fund. These funds may be more sensitive to economic, business, political or other changes affecting similar issuers or securities, which may result in greater fluctuation in the value of their shares. The funds, however, intend to meet certain tax diversification requirements. The other funds are all diversified funds. Each state fund and the Puerto Rico Fund may involve more risk than an investment in a fund that does not focus on securities of a single state or territory. The Federal Intermediate and High Yield Funds are diversified nationally. The High Yield Fund will not invest more than 25% of its total assets in the municipal securities of any one state or territory. STATE Since each state fund invests heavily in municipal securities of its state, events in that state are likely to affect the fund's investments and its performance. These events may include economic or political policy changes, tax base erosion, state constitutional limits on tax increases, budget deficits and other financial difficulties, and changes in the credit ratings assigned to the state's municipal issuers. A negative change in any one of these or other areas could affect the ability of a state's municipal issuers to meet their obligations. It is important to remember that economic, budget and other conditions within a state are unpredictable and can change at any time. To the extent the Federal Intermediate, High Yield or Puerto Rico Funds are invested in a state, events in that state may affect their investments and their performance. U.S. TERRITORIES The Puerto Rico Fund invests heavily in Puerto Rico municipal securities and may invest up to 35% of its total assets in municipal securities issued by other U.S. territories. Each of the other funds also may invest in municipal securities issued by U.S. territories. As with state municipal securities, events in any of these territories where a fund is invested may affect the fund's investments and its performance. YEAR 2000 When evaluating current and potential portfolio positions, Year 2000 is one of the factors the funds' manager considers. Municipal issuers generally are not required to report on their Year 2000 readiness. This makes it more difficult for the manager to evaluate their readiness. There have been reports, however, that many municipal issuers are behind in their efforts to address the Year 2000 problem. The manager, of course, cannot audit each issuer and its major suppliers to verify their Year 2000 readiness. The manager is making efforts, however, to contact the issuers of municipal securities held by the funds to try to assess their Year 2000 readiness. If an issuer in which a fund is invested is adversely affected by Year 2000 problems, it is possible that the issuer's ability to make timely interest and principal payments also will be affected, at least temporarily. This may affect both the amount and timing of the fund's distributions and the fund's performance. It also is likely that the price of the issuer's securities will be adversely affected. A decrease in the value of one or more of the fund's portfolio holdings will have a similar impact on the fund's performance. Please see page 28 for more information. More detailed information about the funds, their policies (including temporary investments), risks and municipal securities ratings can be found in the funds' Statement of Additional Information (SAI). [Begin callout] Mutual fund shares are not deposits or obligations of, or guaranteed or endorsed by, any bank, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency of the U.S. government. Mutual fund shares involve investment risks, including the possible loss of principal. [End callout] [Insert graphic of bull and bear] PERFORMANCE The bar charts and tables below show the volatility of each fund's returns, which is one indicator of the risks of investing in a fund. The bar charts show changes in each fund's returns from year to year over the calendar years shown. The tables show how each fund's average annual total returns compare to those of a broad-based securities market index. Of course, past performance cannot predict or guarantee future results. ARIZONA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.74% 5.80% 12.24% 10.02% 11.18% -4.03% 14.59% 4.21% 8.23% 5.44% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.83% WORST QUARTER: Q1 '94 - -4.32% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------------- Arizona Fund - Class A 2 0.94% 4.60% 7.15% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% Since Inception 1 YEAR (5/1/95) - -------------------------------------------------------------------------------- Arizona Fund - Class C 2 2.82% 6.29% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.05% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. COLORADO FUND - CLASS A ANNUAL TOTAL RETURNS 1 [INSERT BAR GRAPH] 9.90% 5.78% 12.35% 10.00% 12.74% -5.43% 16.07% 4.76% 8.82% 5.73% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 6.62% WORST QUARTER: Q1 '94 - -5.02% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Colorado Fund - Class A 2 1.21% 4.85% 7.45% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Colorado Fund - Class C 2 3.17% 6.81% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.88% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. CONNECTICUT FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.95% 4.93% 10.77% 8.33% 12.32% -5.40% 14.32% 4.48% 8.50% 5.96% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q2 '89 5.60% WORST QUARTER: Q1 '94 - -4.73% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Connecticut Fund - Class A 2 1.44% 4.46% 6.82% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Connecticut Fund - Class C 2 3.35% 6.50% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.04% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. FEDERAL INTERMEDIATE FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] 12.68% -2.71% 14.42% 6.68% 5.27% 5.80% 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.19% WORST QUARTER: Q1 '94 - -3.76% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 SINCE INCEPTION 1 YEAR 5 YEARS (9/21/92) - -------------------------------------------------------------------------------- Federal Intermediate Fund 2 3.40% 5.28% 6.61% Lehman Brothers Municipal 10-Year Bond Index 3 6.76% 6.35% 7.43% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.72%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal 10-Year Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least 10 years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. HIGH YIELD FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.79% 5.11% 12.40% 9.25% 13.27% -2.59% 16.29% 6.16% 10.60% 4.81% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 6.38% WORST QUARTER: Q1 '94 - -3.02% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- High Yield Fund - Class A 2 0.32% 5.94% 7.91% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- High Yield Fund - Class C 2 2.15% 7.51% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.12% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. INDIANA FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] 11.12% 5.98% 12.21% 9.85% 12.83% -4.99% 14.15% 5.02% 8.48% 5.58% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.55% WORST QUARTER: Q1 '94 - -4.82% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - ----------------------------------------------------------------------------- Indiana Fund 2 1.05% 4.55% 7.41% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.90%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. MICHIGAN FUND ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.69% 7.57% 97 98 YEAR [Begin callout] BEST QUARTER: Q2 '97 4.07% WORST QUARTER: Q1 '97 - -0.60% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 SINCE INCEPTION 1 YEAR (7/1/96) - --------------------------------------------------------------------------- Michigan Fund 2 3.04% 7.54% Lehman Brothers Municipal Bond Index 3 6.48% 8.27% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.75%. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. NEW JERSEY FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.39% 6.56% 12.46% 9.19% 10.97% -5.21% 15.58% 4.04% 8.34% 6.11% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 6.44% WORST QUARTER: Q1 '94 - -4.79% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - -------------------------------------------------------------------------- New Jersey Fund - Class A 2 1.59% 4.64% 7.14% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------- New Jersey Fund - Class C 2 3.44% 6.56% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.81% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. OREGON FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.31% 5.55% 12.63% 8.66% 10.91% -4.93% 15.08% 4.32% 8.24% 5.44% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 6.54% WORST QUARTER: Q1 '94 - -4.55% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Oregon Fund - Class A 2 0.93% 4.52% 6.93% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Oregon Fund - Class C 2 2.78% 6.30% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.87% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. PENNSYLVANIA FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 10.32% 3.87% 13.48% 9.83% 11.66% -3.29% 14.34% 4.50% 8.94% 5.48% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q2 '89 5.97% WORST QUARTER: Q1 '94 - -3.64% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Pennsylvania Fund - Class A 2 0.98% 4.91% 7.33% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Pennsylvania Fund - Class C 2 2.80% 6.52% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 0.85% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. PUERTO RICO FUND - CLASS A ANNUAL TOTAL RETURNS 1 [Insert bar graph] 9.75% 5.38% 12.27% 9.12% 10.99% -4.28% 14.49% 5.08% 8.75% 5.74% 89 90 91 92 93 94 95 96 97 98 YEAR [Begin callout] BEST QUARTER: Q1 '95 5.95% WORST QUARTER: Q1 '94 - -4.27% [End callout] AVERAGE ANNUAL TOTAL RETURNS For the periods ended December 31, 1998 1 YEAR 5 YEARS 10 YEARS - --------------------------------------------------------------------------- Puerto Rico Fund - Class A 2 1.21% 4.87% 7.14% Lehman Brothers Municipal Bond Index 3 6.48% 6.23% 8.22% SINCE INCEPTION 1 YEAR (5/1/95) - --------------------------------------------------------------------------- Puerto Rico Fund - Class C 2 3.18% 6.55% Lehman Brothers Municipal Bond Index 3 6.48% 8.10% 1. Figures do not reflect sales charges. If they did, returns would be lower. As of March 31, 1999, the fund's year-to-date return was 1.37% for Class A. 2. Figures reflect sales charges. All fund performance assumes reinvestment of dividends and capital gains. May 1, 1994, Class A implemented a Rule 12b-1 plan, which affects subsequent performance. 3. Source: Standard & Poor's(R) Micropal. The unmanaged Lehman Brothers Municipal Bond Index includes investment grade bonds issued within the last five years as part of a deal of over $50 million and with a maturity of at least two years. It includes reinvested interest. One cannot invest directly in an index, nor is an index representative of the fund's portfolio. [Insert graphic of percentage sign] FEES AND EXPENSES This table describes the fees and expenses that you may pay if you buy and hold shares of a fund.
SHAREHOLDER FEES (fees paid directly from your investment) FEDERAL HIGH ARIZONA COLORADO CONNECTICUT INTERMEDIATE YIELD INDIANA FUND FUND FUND FUND FUND FUND - ---------------------------------------------------------------------------------------------- CLASS A 1 Maximum sales charge (load) as a percentage of offering price 4.25% 4.25% 4.25% 2.25% 4.25% 4.25% Load imposed on purchases 4.25% 4.25% 4.25% 2.25% 4.25% 4.25% Maximum deferred sales charge (load) 3 None None None None None None Exchange fee None None None None None None CLASS B 2 Maximum sales charge (load) as a percentage of offering price - - - - 4.00% - Load imposed on purchases - - - - None - Maximum deferred sales charge (load) - - - - 4.00% - Exchange fee - - - - None - CLASS C 1 Maximum sales charge (load) as a percentage of offering price 1.99% 1.99% 1.99% - 1.99% - Load imposed on purchases 1.00% 1.00% 1.00% - 1.00% - Maximum deferred sales charge (load) 4 0.99% 0.99% 0.99% - 0.99% - Exchange fee None None None - None -
MICHIGAN NEW JERSEY OREGON PENNSYLVANIA PUERTO RICO FUND FUND FUND FUND FUND - ----------------------------------------------------------------------------------------------- CLASS A 1 Maximum sales charge (load) as a percentage of offering price 4.25% 4.25% 4.25% 4.25% 4.25% Load imposed on purchases 4.25% 4.25% 4.25% 4.25% 4.25% Maximum deferred sales charge (load) 3 None None None None None Exchange fee None None None None None CLASS B 2 Maximum sales charge (load) as a percentage of offering price - - - - - Load imposed on purchases - - - - - Maximum deferred sales charge (load) - - - - - Exchange fee - - - - - CLASS C 1 Maximum sales charge (load) as a percentage of offering price - 1.99% 1.99% 1.99% 1.99% Load imposed on purchases - 1.00% 1.00% 1.00% 1.00% Maximum deferred sales charge (load) 4 - 0.99% 0.99% 0.99% 0.99% Exchange fee - None None None None
Please see "Choosing a Share Class" on page 43 for an explanation of how and when these sales charges apply.
ANNUAL FUND OPERATING EXPENSES (expenses deducted from fund assets) FEDERAL HIGH ARIZONA COLORADO CONNECTICUT INTERMEDIATE YIELD INDIANA FUND FUND FUND FUND FUND FUND - ---------------------------------------------------------------------------------------------- CLASS A 1 Management fees 0.48% 0.54% 0.56% 0.58% 5 0.46% 0.63% Distribution and service (12b-1) fees 6 0.09% 0.09% 0.09% 0.10% 0.09% 0.09% Other expenses 0.06% 0.07% 0.07% 0.10% 0.07% 0.10% --------------------------------------------------------------- Total annual fund operating expenses 0.63% 0.70% 0.72% 0.78% 5 0.62% 0.82% --------------------------------------------------------------- CLASS B 2 Management fees - - - - 0.46% - Distribution and service (12b-1) fees 6 - - - - 0.65% - Other expenses - - - - 0.07% - --------------------------------------------------------------- Total annual fund operating expenses - - - - 1.18% - --------------------------------------------------------------- CLASS C 1 Management fees 0.48% 0.54% 0.56% - 0.46% - Distribution and service (12b-1) fees 6 0.65% 0.65% 0.65% - 0.65% - Other expenses 0.06% 0.07% 0.07% - 0.07% - --------------------------------------------------------------- Total annual fund operating expenses 1.19% 1.26% 1.28% - 1.18% - --------------------------------------------------------------- MICHIGAN NEW JERSEY OREGON PENNSYLVANIA PUERTO RICO FUND FUND FUND FUND FUND - ----------------------------------------------------------------------------------------------- CLASS A 1 Management fees 0.63% 5 0.49% 0.51% 0.48% 0.56% Distribution and service (12b-1) fees 6 0.10% 0.09% 0.09% 0.09% 0.09% Other expenses 0.21% 0.07% 0.07% 0.08% 0.09% --------------------------------------------------------------- Total annual fund operating expenses 0.94%5 0.65% 0.67% 0.65% 0.74% --------------------------------------------------------------- CLASS B 2 Management fees - - - - - Distribution and service (12b-1) fees 6 - - - - - Other expenses - - - - - --------------------------------------------------------------- Total annual fund operating expenses - - - - - --------------------------------------------------------------- CLASS C 1 Management fees - 0.49% 0.51% 0.48% 0.56% Distribution and service (12b-1) fees 6 - 0.65% 0.65% 0.65% 0.65% Other expenses - 0.07% 0.07% 0.08% 0.09% --------------------------------------------------------------- Total annual fund operating expenses - 1.21% 1.23% 1.21% 1.30% ---------------------------------------------------------------
1. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. 2. The High Yield Fund began offering Class B shares on January 1, 1999. Annual fund operating expenses are based on the expenses for Class A and C for the fiscal year ended February 28, 1999. The distribution and service (12b-1) fees are based on the maximum fees allowed under Class B's Rule 12b-1 plan. 3. Except for investments of $1 million or more (see page 44). 4. This is equivalent to a charge of 1% based on net asset value. 5. For the fiscal year ended February 28, 1999, the manager had agreed in advance to waive or limit its management fees and to assume as its own expense certain expenses otherwise payable by the fund. With this reduction, management fees were 0.55% for the Federal Intermediate Fund and the Michigan Fund paid no management fees. Total annual fund operating expenses were 0.75% for the Federal Intermediate Fund and 0.25% for the Michigan Fund. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. 6. Because of the distribution and service (12b-1) fees, over the long term you may indirectly pay more than the equivalent of the maximum permitted initial sales charge. EXAMPLE This example can help you compare the cost of investing in a fund with the cost of investing in other mutual funds. The example assumes you invest $10,000 for the periods shown and then sell all of your shares at the end of those periods. The example also assumes your investment has a 5% return each year and the fund's operating expenses remain the same. Although your actual costs may be higher or lower, based on these assumptions your costs would be:
FEDERAL HIGH ARIZONA COLORADO CONNECTICUT INTERMEDIATE YIELD INDIANA FUND FUND FUND FUND FUND FUND - ---------------------------------------------------------------------------------------------- CLASS A 1 Year 1 $487 $493 $495 $303 $486 $505 3 Years $618 $639 $645 $469 $615 $676 5 Years $761 $798 $809 $649 $756 $861 10 Years $1,178 $1,259 $1,281 $1,169 $1,166 $1,395 CLASS B Assuming you sold your shares at the end of the period 1 Year - - - - $520 - 3 Years - - - - $675 - 5 Years - - - - $849 - 10 Years 2 - - - - $1,276 - CLASS B Assuming you stayed in the fund 1 Year - - - - $120 - 3 Years - - - - $375 - 5 Years - - - - $649 - 10 Years 2 - - - - $1,276 - CLASS C 1 Year 3 $318 $325 $327 - $317 - 3 Years $474 $496 $502 - $471 - 5 Years $748 $785 $795 - $743 - 10 Years $1,529 $1,607 $1,630 - $1,517 - MICHIGAN NEW JERSEY OREGON PENNSYLVANIA PUERTO RICO FUND FUND FUND FUND FUND - ----------------------------------------------------------------------------------------------- CLASS A 1 Year 1 $517 $489 $491 $489 $497 3 Years $712 $624 $630 $624 $651 5 Years $923 $772 $782 $772 $819 10 Years $1,531 $1,201 $1,224 $1,201 $1,304 CLASS B Assuming you sold your shares at the end of the period 1 Year - - - - - 3 Years - - - - - 5 Years - - - - - 10 Years - - - - - CLASS B Assuming you stayed in the fund 1 Year - - - - - 3 Years - - - - - 5 Years - - - - - 10 Years - - - - - CLASS C 1 Year 3 - $320 $322 $320 $329 3 Years - $480 $486 $480 $508 5 Years - $758 $769 $758 $806 10 Years - $1,551 $1,574 $1,551 $1,652
1. Assumes a contingent deferred sales charge (CDSC) will not apply. 2. Assumes conversion of Class B shares to Class A shares after eight years, lowering your annual expenses from that time on. 3. For the same Class C investment, your costs would be $220 for the Arizona Fund, $227 for the Colorado Fund, $229 for the Connecticut Fund, $219 for the High Yield Fund, $222 for the New Jersey Fund, $224 for the Oregon Fund, $222 for the Pennsylvania Fund, and $231 for the Puerto Rico Fund if you did not sell your shares at the end of the first year. Your costs for the remaining periods would be the same. [Insert graphic of briefcase] MANAGEMENT Franklin Advisers, Inc. (Advisers), 777 Mariners Island Blvd., San Mateo, CA 94404, is each fund's investment manager. Together, Advisers and its affiliates manage over $227 billion in assets. Before October 1, 1998, the Connecticut Fund's manager was Franklin Investment Advisory Services, Inc. The terms and conditions of the management services Advisers provides are the same as those of the previous manager. The team responsible for the funds' management is: THOMAS KENNY, EXECUTIVE VICE PRESIDENT OF ADVISERS Mr. Kenny has been an analyst or portfolio manager of the Arizona, Colorado, Connecticut, Federal Intermediate, Indiana, Michigan, New Jersey and Oregon Funds since their inception and the High Yield, Pennsylvania and Puerto Rico Funds since 1987. He is the Director of Franklin's Municipal Bond Department. He joined the Franklin Templeton Group in 1986. SHEILA AMOROSO, SENIOR VICE PRESIDENT OF ADVISERS Ms. Amoroso has been an analyst or portfolio manager of the Arizona, Colorado, Federal Intermediate, New Jersey and Oregon Funds since their inception and the High Yield, Pennsylvania and Puerto Rico Funds since 1987. She joined the Franklin Templeton Group in 1986. BEN BARBER, VICE PRESIDENT OF ADVISERS Mr. Barber has been an analyst or portfolio manager of the High Yield and Puerto Rico Funds since 1993. He joined the Franklin Templeton Group in 1991. CARRIE HIGGINS, PORTFOLIO MANAGER OF ADVISERS Ms. Higgins has been an analyst or portfolio manager of the Arizona and Colorado Funds since 1992. She joined the Franklin Templeton Group in 1990. MARK ORSI, VICE PRESIDENT OF ADVISERS Mr. Orsi has been an analyst or portfolio manager of the Federal Intermediate Fund since its inception. He joined the Franklin Templeton Group in 1990. JOHN POMEROY, VICE PRESIDENT OF ADVISERS Mr. Pomeroy has been an analyst or portfolio manager of the Connecticut Fund since 1989 and the Michigan Fund since its inception. He joined the Franklin Templeton Group in 1986. FRANCISCO RIVERA, PORTFOLIO MANAGER OF ADVISERS Mr. Rivera has been an analyst or portfolio manager of the Michigan Fund since its inception. He joined the Franklin Templeton Group in 1994. JOHN WILEY, VICE PRESIDENT OF ADVISERS Mr. Wiley has been an analyst or portfolio manager of the Indiana and Oregon Funds since 1991. He joined the Franklin Templeton Group in 1989. STELLA WONG, VICE PRESIDENT OF ADVISERS Ms. Wong has been an analyst or portfolio manager of the Connecticut, Indiana, New Jersey and Pennsylvania Funds since their inception. She joined the Franklin Templeton Group in 1986. Each fund pays the manager a fee for managing the fund's assets and making its investment decisions. For the fiscal year ended February 28, 1999, the funds paid, the following management fees to the manager: MANAGEMENT FEES (as a percentage of AVERAGE MONTHLY ASSETS) -------------------------- Arizona Fund 0.48% Colorado Fund 0.54% Connecticut Fund 0.56% Federal Intermediate Fund 0.55% 1 High Yield Fund 0.46% Indiana Fund 0.63% Michigan Fund 0.00% 1 New Jersey Fund 0.49% Oregon Fund 0.51% Pennsylvania Fund 0.48% Puerto Rico Fund 0.56% 1. Management fees, before any advance waiver, were 0.58% for the Federal Intermediate Fund and 0.63% for the Michigan Fund. Under an agreement by the manager to waive or limit its fees, the Federal Intermediate Fund and Michigan Funds paid the management fees shown. The manager may end this arrangement at any time upon notice to the fund's Board of Trustees. YEAR 2000 PROBLEM Each fund's business operations depend on a worldwide network of computer systems that contain date fields, including securities trading systems, securities transfer agent operations and stock market links. Many of the systems currently use a two digit date field to represent the date, and unless these systems are changed or modified, they may not be able to distinguish the Year 1900 from the Year 2000 (commonly referred to as the Year 2000 problem). In addition, the fact that the Year 2000 is a leap year may create difficulties for some systems. When the Year 2000 arrives, the funds' operations could be adversely affected if the computer systems used by the manager, its service providers and other third parties it does business with are not Year 2000 ready. For example, the funds' portfolio and operational areas could be impacted, including securities trade processing, interest and dividend payments, securities pricing, shareholder account services, reporting, custody functions and others. The funds' manager and its affiliated service providers are making a concerted effort to take steps they believe are reasonably designed to address their Year 2000 problems. Of course, the funds' ability to reduce the effects of the Year 2000 problem is also very much dependent upon the efforts of third parties over which the funds and their manager may have no control. [Insert graphic of dollar signs and stacks of coins] DISTRIBUTIONS AND TAXES INCOME AND CAPITAL GAINS DISTRIBUTIONS Each fund declares dividends daily from its net investment income and pays them monthly on or about the 20th day of the month. Your account may begin to receive dividends on the day after we receive your investment and will continue to receive dividends through the day we receive a request to sell your shares. Capital gains, if any, may be distributed twice a year. The amount of these distributions will vary and there is no guarantee the fund will pay dividends. Please keep in mind that if you invest in a fund shortly before the fund deducts a capital gain distribution from its net asset value, you will receive some of your investment back in the form of a taxable distribution. TAX CONSIDERATIONS Fund distributions will consist primarily of exempt-interest dividends from interest earned on municipal securities. In general, exempt-interest dividends are exempt from federal income tax. Each fund, however, may invest a portion of its assets in securities that pay income that is not tax-exempt. Fund distributions from such income are taxable to you as ordinary income. Any capital gains a fund distributes are taxable to you as long-term capital gains no matter how long you have owned your shares. Distributions of ordinary income or capital gains are taxable whether you reinvest your distributions in additional fund shares or receive them in cash. [Begin callout] Backup Withholding By law, a fund must withhold 31% of your taxable distributions and proceeds if you do not provide your correct social security or taxpayer identification number, or if the IRS instructs a fund to do so. [End callout] Every January, you will receive a statement that shows the tax status of distributions you received for the previous year. Distributions declared in December but paid in January are taxable as if they were paid in December. When you sell your shares of a fund, you may have a capital gain or loss. For tax purposes, an exchange of your fund shares for shares of a different Franklin Templeton Fund is the same as a sale. The individual tax rate on any gain from the sale or exchange of your shares depends on how long you have held your shares. Exempt-interest dividends are taken into account when determining the taxable portion of your social security or railroad retirement benefits. Each fund may invest a portion of its assets in private activity bonds. The income from these bonds is a preference item when determining your alternative minimum tax. Exempt-interest dividends from interest earned on municipal securities of a state, or its political subdivisions, generally are exempt from that state's personal income tax. Most states, however, do not grant tax-free treatment to interest from municipal securities of other states. Distributions of ordinary income and capital gains, and gains from the sale or exchange of your fund shares generally will be subject to state and local income tax. Non-U.S. investors may be subject to U.S. withholding and estate tax. You should consult your tax advisor about the federal, state, local or foreign tax consequences of your investment in a fund. If you are a resident of Puerto Rico, you should consult with your tax advisor before investing in any of the funds. [Insert graphic of dollar bill] FINANCIAL HIGHLIGHTS The tables below present each fund's financial performance for the past five years or since inception if a fund or class has been in existence for less than five years. This information has been audited by PricewaterhouseCoopers LLP. ARIZONA FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.44 11.24 11.34 11.11 11.58 -------------------------------------------- Net investment income .59 .61 .62 .64 .65 Net realized and unrealized gains (losses) (.01) .29 (.04) .36 (.48) -------------------------------------------- Total from investment operations .58 .90 .58 1.00 .17 -------------------------------------------- Distributions from net investment income (.59) 2 (.61) (.63) (.65) (.64) In excess of net investment Income - (.01) - - - Distributions from net realized gains (.05) (.08) (.05) (.12) - -------------------------------------------- Total distributions (.64) (.70) (.68) (.77) (.64) -------------------------------------------- Net asset value, end of year 11.38 11.44 11.24 11.34 11.11 ============================================ Total return (%) 3 5.17 8.23 5.33 9.24 1.63 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 861,020 810,250 752,335 750,797 720,801 Ratios to average net assets: (%) Expenses .63 .63 .62 .62 .60 Net investment income 5.11 5.40 5.59 5.67 5.86 Portfolio turnover rate (%) 14.11 20.02 16.57 25.12 18.65 ARIZONA FUND (CONT.) CLASS C YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------ 1999 1998 1997 1996 1 - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.51 11.30 11.38 11.15 ------------------------------------ Net investment income .52 .56 .57 .49 Net realized and unrealized gains (losses) (.01) .29 (.03) .34 ------------------------------------ Total from investment operations .51 .85 .54 .83 ------------------------------------ Distributions from net investment income (.52) 2 (.56) (.57) (.48) Distributions from net realized gains (.05) (.08) (.05) (.12) ------------------------------------ Total distributions (.57) (.64) (.62) (.60) ------------------------------------ Net asset value, end of year 11.45 11.51 11.30 11.38 ==================================== Total return (%) 3 4.54 7.67 4.89 7.60 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 23,871 14,537 5,486 1,892 Ratios to average net assets: (%) Expenses 1.19 1.19 1.19 1.20 4 Net investment income 4.55 4.82 5.01 5.05 4 Portfolio turnover rate (%) 14.11 20.02 16.57 25.12 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.002 and $.001 for Class A and C, respectively. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. COLORADO FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.11 11.80 11.84 11.38 11.94 -------------------------------------------- Net investment income .60 .63 .66 .67 .67 Net realized and unrealized gains (losses) .02 .39 (.04) .45 (.57) -------------------------------------------- Total from investment operations .62 1.02 .62 1.12 .10 -------------------------------------------- Dividends from net investment income (.60) (.64) (.66) (.66) (.66) Distributions from net realized gains (.08) (.07) - - - -------------------------------------------- Total distributions (.68) (.71) (.66) (.66) (.66) -------------------------------------------- Net asset value, end of year 12.05 12.11 11.80 11.84 11.38 ============================================ Total return (%) 2 5.24 8.86 5.44 10.12 1.05 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 301,381 266,599 236,609 215,609 194,564 Ratios to average net assets: (%) Expenses .70 .71 .71 .71 .70 Net investment income 4.93 5.28 5.59 5.73 5.94 Portfolio turnover rate (%) 12.60 22.97 14.13 17.58 28.83 CLASS C - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 12.17 11.84 11.87 11.40 ------------------------------------ Net investment income .54 .57 .59 .50 Net realized and unrealized gains (losses) .02 .40 (.02) .46 ------------------------------------ Total from investment operations .56 .97 .57 .96 ------------------------------------ Distributions from net investment income (.54) (.57) (.60) (.49) Distributions from net realized gains (.08) (.07) - - ------------------------------------ Total distributions (.62) (.64) (.60) (.49) ------------------------------------ Net asset value, end of year 12.11 12.17 11.84 11.87 ==================================== Total return (%) 2 4.63 8.39 4.93 8.57 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 21,899 10,855 5,654 1,656 Ratios to average net assets: (%) Expenses 1.26 1.27 1.28 1.29 3 Net investment income 4.38 4.72 4.99 5.12 3 Portfolio turnover rate (%) 12.60 22.97 14.13 17.58 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Annualized. CONNECTICUT FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.23 10.92 10.96 10.64 11.23 -------------------------------------------- Net investment income .58 .60 .61 .62 .62 Net realized and unrealized gains (losses) .04 .32 (.02) .32 (.60) -------------------------------------------- Total from investment operations .62 .92 .59 .94 .02 -------------------------------------------- Distributions from net investment income (.58) 2 (.60) (.63) (.62) (.61) In excess of net investment income - (.01) - - - -------------------------------------------- Total distributions (.58) (.61) (.63) (.62) (.61) -------------------------------------------- Net asset value, end of year 11.27 11.23 10.92 10.96 10.64 ============================================ Total return (%) 3 5.62 8.62 5.52 9.04 .37 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 245,016 203,643 183,649 167,045 155,623 Ratios to average net assets: (%) Expenses .72 .73 .72 .73 .71 Net investment income 5.08 5.41 5.62 5.70 5.83 Portfolio turnover rate (%) 5.87 18.54 14.53 3.88 75.72 CLASS C - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.26 10.94 10.97 10.65 ------------------------------------ Net investment income .52 .55 .60 .47 Net realized and unrealized gains (losses) .03 .31 (.07) .31 ------------------------------------ Total from investment operations .55 .86 .53 .78 ------------------------------------ Distributions from net investment income (.51) 2 (.54) (.56) (.46) ------------------------------------ Net asset value, end of year 11.30 11.26 10.94 10.97 ==================================== Total return (%) 3 5.02 8.08 5.03 7.45 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 23,443 8,636 4,149 1,656 Ratios to average net assets: (%) Expenses 1.28 1.29 1.29 1.30 4 Net investment income 4.53 4.85 5.01 5.12 4 Portfolio turnover rate (%) 5.87 18.54 14.53 3.88 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.002. 3. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 4. Annualized. FEDERAL INTERMEDIATE FUND YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.25 10.94 10.95 10.48 10.80 -------------------------------------------- Net investment income .51 .53 .55 .55 .54 Net realized and unrealized gains (losses) .06 .33 (.01) .47 (.33) -------------------------------------------- Total from investment operations .57 .86 .54 1.02 .21 -------------------------------------------- Distributions from net investment income (.52) (.55) (.55) (.55) (.53) -------------------------------------------- Net asset value, end of year 11.30 11.25 10.94 10.95 10.48 ============================================ Total return (%) 1 5.17 8.02 5.12 9.93 (.20) RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 195,598 139,545 104,715 85,967 73,977 Ratios to average net assets: (%) Expenses .75 .75 .68 .65 .56 Expenses excluding waiver and payments by affiliate .78 .82 .84 .85 .84 Net investment income 4.53 4.83 5.16 5.12 5.25 Portfolio turnover rate (%) 16.57 23.32 22.54 3.35 38.46 1. Total return does not include sales charges. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. HIGH YIELD FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1 1998 1997 1996 2 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.68 11.21 11.19 10.74 11.25 -------------------------------------------- Net investment income .66 .69 .71 .74 .74 Net realized and unrealized gains (losses) (.18) .47 .04 .45 (.51) -------------------------------------------- Total from investment operations .48 1.16 .75 1.19 .23 -------------------------------------------- Distributions from net investment income (.65) (.68) (.73) 3 (.74) (.74) In excess of net investment Income - (.01) - - - Distributions from net realized gains (.02) - - - - -------------------------------------------- Total distributions (.67) (.69) (.73) (.74) (.74) -------------------------------------------- Net asset value, end of year 11.49 11.68 11.21 11.19 10.74 ============================================ Total return (%) 4 4.21 10.64 7.01 11.35 2.28 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1 million) 5,988 5,743 4,505 3,787 3,287 Ratios to average net assets: (%) Expenses .62 .61 .62 .61 .60 Net investment income 5.64 5.98 6.41 6.68 6.92 Portfolio turnover rate (%) 18.55 15.84 6.98 9.23 15.89 CLASS B - ---------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of period 11.51 ------------- Net investment income .11 Distributions from net investment income (.10) ------------- Net asset value, end of period 11.52 ============= Total return (%) 4 .96 RATIOS/SUPPLEMENTAL DATA Net assets, end of period ($ x 1,000) 15,487 Ratios to average net assets: (%) Expenses 1.18 5 Net investment income 5.06 5 Portfolio turnover rate (%) 18.55 HIGH YIELD FUND (CONT.) CLASS C YEAR ENDED FEBRUARY 28, - ------------------------------------------------------------------------ 1999 1 1998 1997 1996 2 - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.75 11.26 11.24 10.81 ------------------------------------ Net investment income .60 .63 .66 .56 Net realized and unrealized gains (losses) (.18) .48 .03 .42 ------------------------------------ Total from investment operations .42 1.11 .69 .98 ------------------------------------ Distributions from net investment income (.59) (.62) (.67) 6 (.55) Distributions from net realized gains (.02) - - - ------------------------------------ Total distributions (.61) (.62) (.67) (.55) ------------------------------------ Net asset value, end of year 11.56 11.75 11.26 11.24 ==================================== Total return (%) 4 3.69 10.15 6.36 9.27 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 631,974 423,264 194,400 48,163 Ratios to average net assets: (%) Expenses 1.18 1.18 1.18 1.18 5 Net investment income 5.07 5.38 5.78 6.07 5 Portfolio turnover rate (%) 18.55 15.84 6.98 9.23 1. For the period January 1, 1999 (effective date) to February 28, 1999 for Class B. 2. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 3. Includes distributions in excess of net investment income in the amount of $.008. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Annualized. 6. Includes distributions in excess of net investment income in the amount of $.003. INDIANA FUND YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 12.07 11.77 11.76 11.40 12.01 -------------------------------------------- Net investment income .62 .65 .66 .67 .66 Net realized and unrealized gains (losses) - .32 .01 .35 (.61) -------------------------------------------- Total from investment operations .62 .97 .67 1.02 .05 -------------------------------------------- Distributions from net investment income (.63) (.65) (.66) (.66) (.66) Distributions from net realized gains (.03) (.02) - - - -------------------------------------------- Total distributions (.66) (.67) (.66) (.66) (.66) -------------------------------------------- Net asset value, end of year 12.03 12.07 11.77 11.76 11.40 ============================================ Total return (%) 1 5.25 8.52 5.91 9.20 .58 Ratios/supplemental data Net assets, end of year ($ x 1,000) 59,014 54,643 51,137 48,949 46,583 Ratios to average net assets: (%) Expenses .82 .82 .82 .80 .81 Net investment income 5.12 5.45 5.69 5.80 5.84 Portfolio turnover rate (%) 18.79 24.08 23.54 10.56 26.49 1. Total return does not include sales charges. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. MICHIGAN FUND YEAR ENDED FEBRUARY 28, - ----------------------------------------------------------------- 1999 1998 1997 1 - ----------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.02 10.42 10.00 ----------------------------- Net investment income .54 .51 .30 Net realized and unrealized gains .12 .67 .32 ----------------------------- Total from investment operations .66 1.18 .62 ----------------------------- Distributions from net investment income (.57) (.58) (.20) Distributions from net realized gains (.02) - - ----------------------------- Total distributions (.59) (.58) (.20) ----------------------------- Net asset value, end of year 11.09 11.02 10.42 ============================= Total return (%) 2 6.15 11.62 6.17 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 17,117 9,268 3,884 Ratios to average net assets: (%) Expenses .25 .25 .34 3 Expenses excluding waiver and payments by affiliate .94 1.01 1.21 3 Net investment income 5.03 5.39 4.90 3 Portfolio turnover rate (%) 16.00 51.81 42.83 1. For the period July, 1 1996 (effective date) to February 28, 1997. 2. Total return does not include sales charges, and is not annualized. 3. Annualized. NEW JERSEY FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.92 11.61 11.68 11.28 11.82 -------------------------------------------- Net investment income .61 .63 .64 .65 .66 Net realized and unrealized gains (losses) .05 .32 (.06) .39 (.55) -------------------------------------------- Total from investment operations .66 .95 .58 1.04 .11 -------------------------------------------- Distributions from net investment income (.62) (.64) (.65) (.64) (.65) -------------------------------------------- Net asset value, end of year 11.96 11.92 11.61 11.68 11.28 ============================================ Total return (%) 2 5.63 8.37 5.13 9.43 1.12 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 681,818 636,929 574,691 564,864 533,973 Ratios to average net assets: (%) Expenses .65 .66 .64 .65 .63 Net investment income 5.06 5.34 5.58 5.65 5.86 Portfolio turnover rate (%) 5.43 12.77 8.87 12.04 31.05 CLASS C - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.98 11.66 11.72 11.30 ------------------------------------ Net investment income .54 .56 .57 .49 Net realized and unrealized gains (losses) .06 .33 (.05) .40 ------------------------------------ Total from investment operations .60 .89 .52 .89 ------------------------------------ Distributions from net investment income (.55) (.57) (.58) (.47) ------------------------------------ Net asset value, end of year 12.03 11.98 11.66 11.72 ==================================== Total return (%) 2 5.09 7.84 4.57 8.02 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 48,715 28,139 13,095 4,542 Ratios to average net assets: (%) Expenses 1.21 1.21 1.21 1.23 3 Net investment income 4.50 4.77 5.01 5.15 3 Portfolio turnover rate (%) 5.43 12.77 8.87 12.04 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Annualized. OREGON FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.86 11.55 11.60 11.22 11.70 -------------------------------------------- Net investment income .59 .62 .63 .63 .63 Net realized and unrealized gains (losses) (.01) .31 (.05) .38 (.49) -------------------------------------------- Total from investment operations .58 .93 .58 1.01 .14 -------------------------------------------- Distributions from net investment income (.61) (.62) (.63) (.63) (.62) -------------------------------------------- Net asset value, end of year 11.83 11.86 11.55 11.60 11.22 ============================================ Total return (%) 2 5.12 8.21 5.13 9.19 1.36 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 483,664 427,022 384,003 375,415 349,458 Ratios to average net assets: (%) Expenses .67 .67 .66 .66 .65 Net investment income 5.00 5.33 5.52 5.51 5.71 Portfolio turnover rate (%) 10.65 12.18 4.47 6.52 26.44 CLASS C - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 11.92 11.61 11.65 11.23 ------------------------------------ Net investment income .53 .56 .56 .47 Net realized and unrealized gains (losses) - .31 (.04) .41 ------------------------------------ Total from investment operations .53 .87 .52 .88 ------------------------------------ Distributions from net investment income (.55) (.56) (.56) (.46) ------------------------------------ Net asset value, end of year 11.90 11.92 11.61 11.65 ==================================== Total return (%) 2 4.59 7.66 4.59 7.99 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 32,962 15,946 7,100 2,044 Ratios to average net assets: (%) Expenses 1.23 1.22 1.23 1.24 3 Net investment income 4.44 4.74 4.93 4.87 3 Portfolio turnover rate (%) 10.65 12.18 4.47 6.52 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Annualized. PENNSYLVANIA FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 10.56 10.39 10.44 10.16 10.56 -------------------------------------------- Net investment income .55 .58 .60 .62 .62 Net realized and unrealized gains (losses) (.02) .32 (.04) .29 (.41) -------------------------------------------- Total from investment operations .53 .90 .56 .91 .21 -------------------------------------------- Distributions from net investment income (.55) (.58) (.61) (.63) (.61) In excess of net investment income (.01) (.01) - - - Distributions from net realized gains (.01) (.14) - - - -------------------------------------------- Total distributions (.57) (.73) (.61) (.63) (.61) -------------------------------------------- Net asset value, end of year 10.52 10.56 10.39 10.44 10.16 ============================================ Total return (%) 2 5.11 8.90 5.53 9.15 2.22 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 758,942 713,141 658,339 639,847 587,366 Ratios to average net assets: (%) Expenses .65 .65 .64 .64 .63 Net investment income 5.17 5.49 5.84 5.96 6.15 Portfolio turnover rate (%) 11.11 12.74 22.24 9.71 12.91 CLASS C - ------------------------------------------------------------------------ PER SHARE DATA ($) Net asset value, beginning of year 10.61 10.43 10.47 10.17 ------------------------------------ Net investment income .49 .52 .55 .47 Net realized and unrealized gains (losses) (.03) .33 (.05) .30 ------------------------------------ Total from investment operations .46 .85 .50 .77 ------------------------------------ Distributions from net investment income (.49) 3 (.53) (.54) (.47) Distributions from net realized gains (.01) (.14) - - ------------------------------------ Total distributions (.50) (.67) (.54) (.47) ------------------------------------ Net asset value, end of year 10.57 10.61 10.43 10.47 ==================================== Total return (%) 2 4.50 8.35 4.98 7.71 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 41,917 25,899 11,935 3,110 Ratios to average net assets: (%) Expenses 1.21 1.21 1.21 1.22 4 Net investment income 4.61 4.89 5.22 5.36 4 Portfolio turnover rate (%) 11.11 12.74 22.24 9.71 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 3. Includes distributions in excess of net investment income in the amount of $.004. 4. Annualized. PUERTO RICO FUND CLASS A YEAR ENDED FEBRUARY 28, - -------------------------------------------------------------------------------- 1999 1998 1997 1996 1 1995 - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.86 11.51 11.59 11.31 11.83 -------------------------------------------- Net investment income .60 .62 .65 .66 .67 Net realized and unrealized gains (losses) .06 .36 .02 .30 (.50) -------------------------------------------- Total from investment operations .66 .98 .67 .96 .17 -------------------------------------------- Distributions from net investment income (.60) 3 (.62) (.65)3 (.67) 2 (.69) Distributions from net realized gains (.04) (.01) (.10) (.01) - -------------------------------------------- Total distributions (.64) (.63) (.75) (.68) (.69) -------------------------------------------- Net asset value, end of year 11.88 11.86 11.51 11.59 11.31 ============================================ Total return (%) 4 5.68 8.78 6.03 8.68 1.60 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 218,753 210,325 192,525 190,577 176,888 Ratios to average net assets: (%) Expenses .74 .75 .73 .74 .73 Net investment income 4.98 5.35 5.62 5.71 5.95 Portfolio turnover rate (%) 20.19 7.94 21.09 27.99 18.30 CLASS C - -------------------------------------------------------------------------------- PER SHARE DATA ($) Net asset value, beginning of year 11.87 11.53 11.62 11.32 ------------------------------------ Net investment income .53 .56 .58 .50 Net realized and unrealized gains .06 .34 .02 .30 ------------------------------------ Total from investment operations .59 .90 .60 .80 ------------------------------------ Distributions from net investment income (.53) 5 (.55) (.59) (.49) Distributions from net realized gains (.04) (.01) (.10) (.01) ------------------------------------ Total distributions (.57) (.56) (.69) (.50) ------------------------------------ Net asset value, end of year 11.89 11.87 11.53 11.62 ==================================== Total return (%) 4 5.09 8.07 5.33 7.21 RATIOS/SUPPLEMENTAL DATA Net assets, end of year ($ x 1,000) 7,050 3,615 1,679 533 Ratios to average net assets: (%) Expenses 1.30 1.31 1.30 1.32 6 Net investment income 4.43 4.78 5.04 5.16 6 Portfolio turnover rate (%) 20.19 7.94 21.09 27.99 1. For the period May 1, 1995 (effective date) to February 29, 1996 for Class C. 2. Includes distributions in excess of net investment income in the amount of $.001. 3. Includes distributions in excess of net investment income in the amount of $.006. 4. Total return does not include sales charges, and is not annualized. Before May 1, 1994, dividends from net investment income were reinvested at the offering price. 5. Includes distributions in excess of net investment income in the amount of $.004. 6. Annualized. YOUR ACCOUNT [Insert graphic of pencil marking an X] CHOOSING A SHARE CLASS Each class has its own sales charge and expense structure, allowing you to choose the class that best meets your situation. Your investment representative can help you decide. CLASS C CLASS B (ALL FUNDS EXCEPT CLASS A (HIGH YIELD FUND ONLY) FEDERAL INTER- MEDIATE, INDIANA AND MICHIGAN) - -------------------------------------------------------------------------------- o Initial sales charge of o No initial sales charge o Initial sales charge 2.25% of less (Federal of 1% Intermediate Fund) or 4.25% or less (all other funds) o Deferred sales charge o Deferred sales charge o Deferred sales charge of 1% on purchases of of 4% or less on of 1% on shares you $1 million or more sold shares you sell within sell within 18 months within 12 months six years o Lower annual expenses o Higher annual expenses o Higher annual than Class B or C due than Class A (same as expenses than Class A to lower distribution Class C) due to higher (same as Class B) due fees distribution fees. to higher Automatic conversion distribution fees. No to Class A shares conversion to Class A after eight years, shares, so annual reducing future annual expenses do not expenses. decrease. BEFORE JANUARY 1, 1999, CLASS A SHARES WERE DESIGNATED CLASS I AND CLASS C SHARES WERE DESIGNATED CLASS II. THE HIGH YIELD FUND BEGAN OFFERING CLASS B SHARES ON JANUARY 1, 1999.
SALES CHARGES - CLASS A THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT - --------------------------------------------------------------------------------------------- All funds (except Federal Intermediate) Under $100,000 4.25 4.44 $100,000 but under $250,000 3.50 3.63 $250,000 but under $500,000 2.50 2.56 $500,000 but under $1 million 2.00 2.04 FEDERAL INTERMEDIATE FUND - ------------------------- Under $100,000 2.25 2.30 $100,000 but under $250,000 1.75 1.78 $250,000 but under $500,000 1.25 1.26 $500,000 but under $1 million 1.00 1.01
INVESTMENTS OF $1 MILLION OR MORE If you invest $1 million or more, either as a lump sum or through our cumulative quantity discount or letter of intent programs (see page 47), you can buy Class A shares without an initial sales charge. However, there is a 1% contingent deferred sales charge (CDSC) on any shares you sell within 12 months of purchase. The way we calculate the CDSC is the same for each class (please see page 46). The CDSC will not apply to purchases over $250 million in the High Yield Fund. DISTRIBUTION AND SERVICE (12B-1) FEES Class A has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution fees of up to 0.15% per year for the Michigan Fund (although the fund is currently only reimbursing up to 0.10%), and 10% per year for the remaining funds, to those who sell and distribute Class A shares and provide other services to shareholders. Because these fees are paid out of Class A's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. SALES CHARGES - CLASS B (HIGH YIELD FUND ONLY) IF YOU SELL YOUR SHARES WITHIN THIS % IS DEDUCTED FROM THIS MANY YEARS AFTER BUYING THEM YOUR PROCEEDS AS A CDSC - ------------------------------------------------------------------- 1 Year 4 2 Years 4 3 Years 3 4 Years 3 5 Years 2 6 Years 1 7 Years 0 With Class B shares, there is no initial sales charge. However, there is a CDSC if you sell your shares within six years, as described in the table above. The way we calculate the CDSC is the same for each class (please see page 46). After 8 years, your Class B shares automatically convert to Class A shares, lowering your annual expenses from that time on. MAXIMUM PURCHASE AMOUNT The maximum amount you may invest in Class B shares at one time is $249,999. We place any investment of $250,000 or more in Class A shares, since a reduced initial sales charge is available and Class A's annual expenses are lower. DISTRIBUTION AND SERVICE (12B-1) FEES Class B has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution and other fees of up to 0.65% per year for the sale of Class B shares and for services provided to shareholders. Because these fees are paid out of Class B's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges.
SALES CHARGES - CLASS C THE SALES CHARGE MAKES UP THIS % WHICH EQUALS THIS % WHEN YOU INVEST THIS AMOUNT OF THE OFFERING PRICE OF YOUR NET INVESTMENT - ------------------------------------------------------------------------------------- Under $1 million 1.00 1.01
WE PLACE ANY INVESTMENT OF $1 MILLION OR MORE IN CLASS A SHARES, SINCE THERE IS NO INITIAL SALES CHARGE AND CLASS A'S ANNUAL EXPENSES ARE LOWER. CDSC There is a 1% contingent deferred sales charge (CDSC) on any Class C shares you sell within 18 months of purchase. The way we calculate the CDSC is the same for each class (please see below). DISTRIBUTION AND SERVICE (12B-1) FEES Class C has a distribution plan, sometimes known as a Rule 12b-1 plan, that allows the fund to pay distribution and other fees of up to 0.65% per year for the sale of Class C shares and for services provided to shareholders. Because these fees are paid out of Class C's assets on an on-going basis, over time these fees will increase the cost of your investment and may cost you more than paying other types of sales charges. CONTINGENT DEFERRED SALES CHARGE (CDSC) - CLASS A, B & C The CDSC for each class is based on the current value of the shares being sold or their net asset value when purchased, whichever is less. There is no CDSC on shares you acquire by reinvesting your dividends or capital gains distributions. [Begin callout] The HOLDING PERIOD FOR THE CDSC begins on the day you buy your shares. Your shares will age one month on that same date the next month and each following month. For example, if you buy shares on the 18th of the month, they will age one month on the 18th day of the next month and each following month. [End callout] To keep your CDSC as low as possible, each time you place a request to sell shares we will first sell any shares in your account that are not subject to a CDSC. If there are not enough of these to meet your request, we will sell the shares in the order they were purchased. We will use this same method if you exchange your shares into another Franklin Templeton Fund (please see page 51 for exchange information). SALES CHARGE REDUCTIONS AND WAIVERS If you qualify for any of the sales charge reductions or waivers below, please let us know at the time you make your investment to help ensure you receive the lower sales charge. QUANTITY DISCOUNTS We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases of Class A shares. [Begin callout] The FRANKLIN TEMPLETON FUNDS include all of the Franklin Templeton U.S. registered mutual funds, except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. [End callout] o CUMULATIVE QUANTITY DISCOUNT - lets you combine all of your shares in the Franklin Templeton Funds for purposes of calculating the sales charge. You also may combine the shares of your spouse, and your children or grandchildren, if they are under the age of 21. Certain company and retirement plan accounts also may be included. o LETTER OF INTENT (LOI) - expresses your intent to buy a stated dollar amount of shares over a 13-month period and lets you receive the same sales charge as if all shares had been purchased at one time. We will reserve a portion of your shares to cover any additional sales charge that may apply if you do not buy the amount stated in your LOI. TO SIGN UP FOR THESE PROGRAMS, COMPLETE THE APPROPRIATE SECTION OF YOUR ACCOUNT APPLICATION. REINSTATEMENT PRIVILEGE If you sell shares of a Franklin Templeton Fund, you may reinvest some or all of the proceeds within 365 days without an initial sales charge. The proceeds must be reinvested within the same share class, except proceeds from the sale of Class B shares will be reinvested in Class A shares. If you paid a CDSC when you sold your Class A or C shares, we will credit your account with the amount of the CDSC paid but a new CDSC will apply. For Class B shares reinvested in Class A, a new CDSC will not apply, although your account will not be credited with the amount of any CDSC paid when you sold your Class B shares. Proceeds immediately placed in a Franklin Bank Certificate of Deposit (CD) also may be reinvested without an initial sales charge if you reinvest them within 365 days from the date the CD matures, including any rollover. This privilege does not apply to shares you buy and sell under our exchange program. Shares purchased with the proceeds from a money fund may be subject to a sales charge. SALES CHARGE WAIVERS Class A shares may be purchased without an initial sales charge or CDSC by various individuals and institutions or by investors who reinvest certain distributions and proceeds within 365 days. The CDSC for each class also may be waived for certain redemptions and distributions. If you would like information about available sales charge waivers, call your investment representative or call Shareholder Services at 1-800/632-2301. A list of available sales charge waivers also may be found in the Statement of Additional Information (SAI). GROUP INVESTMENT PROGRAM Allows established groups of 11 or more investors to invest as a group. For sales charge purposes, the group's investments are added together. There are certain other requirements and the group must have a purpose other than buying fund shares at a discount.
[Insert graphic of paper with lines and someone writing] BUYING SHARES MINIMUM INVESTMENTS - -------------------------------------------------------------------------------------------- INITIAL ADDITIONAL - -------------------------------------------------------------------------------------------- Regular accounts $1,000 $50 UGMA/UTMA accounts $100 $50 Broker-dealer sponsored wrap account programs $250 $50 Full-time employees, officers, trustees and directors of $100 $50 Franklin Templeton entities, and their immediate family members
ACCOUNT APPLICATION If you are opening a new account, please complete and sign the enclosed account application. Make sure you indicate the share class you have chosen. If you do not indicate a class, we will place your purchase in Class A shares. To save time, you can sign up now for services you may want on your account by completing the appropriate sections of the application (see the next page). BUYING SHARES - -------------------------------------------------------------------------------- OPENING AN ACCOUNT ADDING TO AN ACCOUNT - -------------------------------------------------------------------------------- [Insert graphic of hands Contact your investment Contact your investment shaking] representative representative THROUGH YOUR INVESTMENT REPRESENTATIVE - -------------------------------------------------------------------------------- [Insert graphic of Make your check payable Make your check payable envelope] to the fund. to the fund. Include your account number on BY MAIL Mail the check and your the check. signed application to Investor Services. Fill out the deposit slip from your account statement. If you do not have a slip, include a note with your name, the fund name, and your account number. Mail the check and deposit slip or note to Investor Services. - -------------------------------------------------------------------------------- [Insert graphic of three Call to receive a wire Call to receive a wire lightning bolts] control number and wire control number and wire instructions. instructions. BY WIRE Wire the funds and mail To make a same day wire 1-800/632-2301 your signed application investment, please call (or 1-650/312-2000 to Investor Services. us by 1:00 p.m. pacific collect) Please include the wire time and make sure your control number or your wire arrives by 3:00 p.m. new account number on the application. To make a same day wire investment, please call us by 1:00 p.m. pacific time and make sure your wire arrives by 3:00 p.m. - -------------------------------------------------------------------------------- [Insert graphic of two Call Shareholder Services Call Shareholder arrows pointing in at the number below, or Services at the number opposite directions] send signed written below or our automated instructions. The TeleFACTS system, or BY EXCHANGE TeleFACTS system cannot send signed written be used to open a new instructions. TeleFACTS(R) account. 1-800/247-1753 (Please see page 51 for (around-the-clock (Please see page 51 for information on access) information on exchanges.) exchanges.) - -------------------------------------------------------------------------------- FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151, SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of person with handset] INVESTOR SERVICES AUTOMATIC INVESTMENT PLAN This plan offers a convenient way for you to invest in a fund by automatically transferring money from your checking or savings account each month to buy shares. The minimum investment to open an account with an automatic investment plan is $50. To sign up, complete the appropriate section of your account application. AUTOMATIC PAYROLL DEDUCTION You may be able to invest automatically in Class A shares of a fund by transferring money from your paycheck to the fund by electronic funds transfer. If you are interested, indicate on your application that you would like to receive an Automatic Payroll Deduction Program kit. DISTRIBUTION OPTIONS You may reinvest distributions you receive from a fund in an existing account in the same share class* of the fund or another Franklin Templeton Fund. Initial sales charges and CDSCs will not apply if you reinvest your distributions within 365 days. You can also have your distributions deposited in a bank account, or mailed by check. Deposits to a bank account may be made by electronic funds transfer. Please indicate on your application the distribution option you have chosen, otherwise we will reinvest your distributions in the same share class of the fund. *Class B and C shareholders may reinvest their distributions in Class A shares of any Franklin Templeton money fund. TELEFACTS(R) Our TeleFACTS system offers around-the-clock access to information about your account or any Franklin Templeton Fund. This service is available from touch-tone phones at 1-800/247-1753. For a free TeleFACTS brochure, call 1-800/DIAL BEN. TELEPHONE PRIVILEGES You will automatically receive telephone privileges when you open your account, allowing you and your investment representative to sell or exchange your shares and make certain other changes to your account by phone. For accounts with more than one registered owner, telephone privileges also allow the funds to accept written instructions signed by only one owner for transactions and account changes that could otherwise be made by phone. For all other transactions and changes, all registered owners must sign the instructions. As long as we take certain measures to verify telephone requests, we will not be responsible for any losses that may occur from unauthorized requests. Of course, you can decline telephone exchange or redemption privileges on your account application. EXCHANGE PRIVILEGE You can exchange shares between most Franklin Templeton Funds within the same class*, generally without paying any additional sales charges. If you exchange shares held for less than six months, however, you may be charged the difference between the initial sales charge of the two funds if the difference is more than 0.25%. If you exchange shares from a money fund, a sales charge may apply no matter how long you have held the shares. [Begin callout] An EXCHANGE is really two transactions: a sale of one fund and the purchase of another. In general, the same policies that apply to purchases and sales apply to exchanges, including minimum investment amounts. Exchanges also have the same tax consequences as ordinary sales and purchases. [End callout] Generally exchanges may only be made between identically registered accounts, unless you send written instructions with a signature guarantee. Any CDSC will continue to be calculated from the date of your initial investment and will not be charged at the time of the exchange. The purchase price for determining a CDSC on exchanged shares will be the price you paid for the original shares. If you exchange shares subject to a CDSC into a Class A money fund, the time your shares are held in the money fund will not count towards the CDSC holding period. *Certain Class Z shareholders of Franklin Mutual Series Fund Inc. may exchange into Class A without any sales charge. Advisor Class shareholders of another Franklin Templeton Fund also may exchange into Class A without any sales charge. Advisor Class shareholders who exchange their shares for Class A shares and later decide they would like to exchange into another fund that offers Advisor Class may do so. If you exchange your Class B shares for the same class of shares of another Franklin Templeton Fund, the time your shares are held in that fund will count towards the eight year period for automatic conversion to Class A shares. Frequent exchanges can interfere with fund management or operations and drive up costs for all shareholders. To protect shareholders, there are limits on the number and amount of exchanges you may make (please see "Market Timers" on page 56). SYSTEMATIC WITHDRAWAL PLAN This plan allows you to automatically sell your shares and receive regular payments from your account. A CDSC may apply to withdrawals that exceed certain amounts. Certain terms and minimums apply. To sign up, complete the appropriate section of your application. [Insert graphic of certificate] SELLING SHARES You can sell your shares at any time. SELLING SHARES IN WRITING Generally requests to sell $100,000 or less can be made over the phone or with a simple letter. Sometimes, however, to protect you and the fund we will need written instructions signed by all registered owners, with a signature guarantee for each owner, if: [Begin callout] A SIGNATURE GUARANTEE helps protect your account against fraud. You can obtain a signature guarantee at most banks and securities dealers. A notary public CANNOT provide a signature guarantee. [End callout] o you are selling more than $100,000 worth of shares o you want your proceeds paid to someone who is not a registered owner o you want to send your proceeds somewhere other than the address of record, or preauthorized bank or brokerage firm account We also may require a signature guarantee on instructions we receive from an agent, not the registered owners, or when we believe it would protect the fund against potential claims based on the instructions received. SELLING RECENTLY PURCHASED SHARES If you sell shares recently purchased with a check or draft, we may delay sending you the proceeds until your check or draft has cleared, which may take seven business days or more. A certified or cashier's check may clear in less time. REDEMPTION PROCEEDS Your redemption check will be sent within seven days after we receive your request in proper form. We are not able to receive or pay out cash in the form of currency. Redemption proceeds may be delayed if we have not yet received your signed account application. SELLING SHARES - -------------------------------------------------------------------------------- TO SELL SOME OR ALL OF YOUR SHARES - -------------------------------------------------------------------------------- [Insert graphic of hands shaking] Contact your investment representative Through your investment representative - -------------------------------------------------------------------------------- [Insert graphic of envelope] Send written instructions and endorsed share certificates (if you hold share certificates) By Mail to Investor Services. Corporate, partnership or trust accounts may need to send additional documents. Specify the fund, the account number and the dollar value or number of shares you wish to sell. If you own both Class A and B shares, also specify the class of shares, otherwise we will sell your Class A shares first. Be sure to include all necessary signatures and any additional documents, as well as signature guarantees if required. A check will be mailed to the name(s) and address on the account, or otherwise according to your written instructions. - -------------------------------------------------------------------------------- [Insert graphic of phone] As long as your transaction is for $100,000 or less, you do not hold share certificates By Phone and you have not changed your address by phone within the last 15 days, you can sell 1-800/632-2301 your shares by phone. A check will be mailed to the name(s) and address on the account. Written instructions, with a signature guarantee, are required to send the check to another address or to make it payable to another person. - -------------------------------------------------------------------------------- [Insert graphic of three You can call or write to have redemption lightning bolts] proceeds of $1,000 or more wired to a bank or escrow account. See the policies above for By Wire selling shares by mail or phone. Before requesting a bank wire, please make sure we have your bank account information on file. If we do not have this information, you will need to send written instructions with your bank's name and address, your bank account number, the ABA routing number, and a signature guarantee. Requests received in proper form by 1:00 p.m. pacific time will be wired the next business day. - -------------------------------------------------------------------------------- [Insert graphic of two arrows Obtain a current prospectus for the fund you pointing in are considering. opposite directions] Call Shareholder Services at the number below By Exchange or our automated TeleFACTS system, or send signed written instructions. See the policies TeleFACTS(R) above for selling shares by mail or phone. 1-800/247-1753 (around-the-clock If you hold share certificates, you will need access) to return them to the fund before your exchange can be processed. - -------------------------------------------------------------------------------- FRANKLIN TEMPLETON INVESTOR SERVICES P.O. BOX 997151, SACRAMENTO, CA 95899-9983 CALL TOLL-FREE: 1-800/632-2301 (MONDAY THROUGH FRIDAY 5:30 A.M. TO 5:00 P.M., PACIFIC TIME SATURDAY 6:30 A.M. TO 2:30 P.M., PACIFIC TIME) [Insert graphic of paper and pen] ACCOUNT POLICIES CALCULATING SHARE PRICE Each fund calculates its net asset value per share (NAV) each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). Each class's NAV is calculated by dividing its net assets by the number of its shares outstanding. [Begin callout] When you buy shares, you pay the offering price. The offering price is the NAV plus any applicable sales charge. When you sell shares, you receive the NAV minus any applicable contingent deferred sales charge (CDSC). [End callout] Each fund's assets are generally valued at their market value. If market prices are unavailable, or if an event occurs after the close of the trading market that materially affects the values, assets may be valued at their fair value. Requests to buy and sell shares are processed at the NAV next calculated after we receive your request in proper form. ACCOUNTS WITH LOW BALANCES If the value of your account falls below $250 ($50 for employee and UGMA/UTMA accounts) because you sell some of your shares, we may mail you a notice asking you to bring the account back up to its applicable minimum investment amount. If you choose not to do so within 30 days, we may close your account and mail the proceeds to the address of record. You will not be charged a CDSC if your account is closed for this reason. STATEMENTS AND REPORTS You will receive confirmations and account statements that show your account transactions. You also will receive the funds' financial reports every six months. To reduce fund expenses, we try to identify related shareholders in a household and send only one copy of the financial reports. If you need additional copies, please call 1-800/DIAL BEN. If there is a dealer or other investment representative of record on your account, he or she also will receive confirmations, account statements and other information about your account directly from the fund. STREET OR NOMINEE ACCOUNTS You may transfer your shares from the street or nominee name account of one dealer to another, as long as both dealers have an agreement with Franklin Templeton Distributors, Inc. We will process the transfer after we receive authorization in proper form from your delivering securities dealer. JOINT ACCOUNTS Unless you specify a different registration, accounts with two or more owners are registered as "joint tenants with rights of survivorship" (shown as "Jt Ten" on your account statement). To make any ownership changes to a joint account, all owners must agree in writing, regardless of the law in your state. MARKET TIMERS The funds do not allow investments by market timers. You will be considered a market timer if you have (i) requested an exchange out of the fund within two weeks of an earlier exchange request, or (ii) exchanged shares out of the fund more than twice in a calendar quarter, or (iii) exchanged shares equal to at least $5 million, or more than 1% of the fund's net assets, or (iv) otherwise seem to follow a timing pattern. Shares under common ownership or control are combined for these limits. ADDITIONAL POLICIES Please note that the funds maintain additional policies and reserve certain rights, including: o The funds may refuse any order to buy shares, including any purchase under the exchange privilege. o At any time, the funds may change their investment minimums or waive or lower their minimums for certain purchases. o The funds may modify or discontinue the exchange privilege on 60 days' notice. o You may only buy shares of a fund eligible for sale in your state or jurisdiction. o In unusual circumstances, we may temporarily suspend redemptions, or postpone the payment of proceeds, as allowed by federal securities laws. o For redemptions over a certain amount, each fund reserves the right to make payments in securities or other assets of the fund, in the case of an emergency or if the payment by check or wire would be harmful to existing shareholders. o To permit investors to obtain the current price, dealers are responsible for transmitting all orders to the funds promptly. DEALER COMPENSATION Qualifying dealers who sell fund shares may receive sales commissions and other payments. These are paid by Franklin Templeton Distributors, Inc. (Distributors) from sales charges, distribution and service (12b-1) fees and its other resources. CLASS B ALL FUNDS (HIGH YIELD (EXCEPT FEDERAL INTERMEDIATE) CLASS A FUND ONLY) CLASS C - ------------------------------------------------------------------------------- COMMISSION (%) - 3.00 2.00 Investment under $100,000 4.00 - - $100,000 but under $250,000 3.25 - - $250,000 but under $500,000 2.25 - - $500,000 but under $1 million 1.85 - - $1 million or more up to 0.75 1 - - 12B-1 FEE TO DEALER 0.10 0.15 2 0.65 3 FEDERAL INTERMEDIATE FUND - ------------------------- COMMISSION (%) - Investment under $100,000 2.00 $100,000 but under $250,000 1.50 $250,000 but under $500,000 1.00 $500,000 but under $1 million 0.85 $1 million or more up to 0.75 1 12B-1 FEE TO DEALER 0.10 A dealer commission of up to 0.25% may be paid on Class A NAV purchases by certain trust companies and bank trust departments, eligible governmental authorities, and broker-dealers or others on behalf of clients participating in comprehensive fee programs. 1. During the first year after purchase, dealers may not be eligible to receive the 12b-1 fee. 2. Dealers may be eligible to receive up to 0.15% from the date of purchase. After 8 years, Class B shares convert to Class A shares and dealers may then receive the 12b-1 fee applicable to Class A. 3. Dealers may be eligible to receive up to 0.15% during the first year after purchase and may be eligible to receive the full 12b-1 fee starting in the 13th month. [Insert graphic of question mark] QUESTIONS If you have any questions about the funds or your account, you can write to us at P.O. Box 997151, Sacramento, CA 95899-9983. You can also call us at one of the following numbers. For your protection and to help ensure we provide you with quality service, all calls may be monitored or recorded. HOURS (PACIFIC TIME, DEPARTMENT NAME TELEPHONE NUMBER MONDAY THROUGH FRIDAY) - -------------------------------------------------------------------------------- Shareholder Services 1-800/632-2301 5:30 a.m. to 5:00 p.m. 6:30 a.m. to 2:30 p.m. (Saturday) Fund Information 1-800/DIAL BEN 5:30 a.m. to 8:00 p.m. (1-800/342-5236) 6:30 a.m. to 2:30 p.m. (Saturday) Retirement Plan Services 1-800/527-2020 5:30 a.m. to 5:00 p.m. Dealer Services 1-800/524-4040 5:30 a.m. to 5:00 p.m. Institutional Services 1-800/321-8563 6:00 a.m. to 5:00 p.m. TDD (hearing impaired) 1-800/851-0637 5:30 a.m. to 5:00 p.m. FOR MORE INFORMATION You can learn more about each fund in the following documents: ANNUAL/SEMIANNUAL REPORT TO SHAREHOLDERS Includes a discussion of recent market conditions and fund strategies, financial statements, detailed performance information, portfolio holdings, and the auditor's report. STATEMENT OF ADDITIONAL INFORMATION (SAI) Contains more information about each fund, its investments and policies. It is incorporated by reference (is legally a part of this prospectus). For a free copy of the current annual/semiannual report or the SAI, please contact your investment representative or call us at the number below. FRANKLIN(R)TEMPLETON(R) 1-800/DIAL BEN(R) (1-800/342-5236) TDD (Hearing Impaired) 1-800/851-0637 www.franklin-templeton.com You can also obtain information about each fund by visiting the SEC's Public Reference Room in Washington D.C. (phone 1-800/SEC-0330) or by sending your request and a duplicating fee to the SEC's Public Reference Section, Washington, DC 20549-6009. You can also visit the SEC's Internet site at http://www.sec.gov. Investment Company Act file # 811-4149 TF3 P 07/99 FRANKLIN TAX-FREE TRUST FRANKLIN ARIZONA INSURED TAX-FREE INCOME FUND FRANKLIN FLORIDA INSURED TAX-FREE INCOME FUND FRANKLIN INSURED TAX-FREE INCOME FUND FRANKLIN MASSACHUSETTS INSURED TAX-FREE INCOME FUND FRANKLIN MICHIGAN INSURED TAX-FREE INCOME FUND FRANKLIN MINNESOTA INSURED TAX-FREE INCOME FUND FRANKLIN OHIO INSURED TAX-FREE INCOME FUND STATEMENT OF ADDITIONAL INFORMATION JULY 1, 1999 [INSERT FRANKLIN TEMPLETON BEN HEAD] P.O. BOX 997151, SACRAMENTO, CA95899-9983 1-800/DIAL BEN(R) This Statement of Additional Information (SAI) is not a prospectus. It contains information in addition to the information in the funds' prospectus. The funds' prospectus, dated July 1, 1999, which we may amend from time to time, contains the basic information you should know before investing in the funds. You should read this SAI together with the funds' prospectus. The audited financial statements and auditor's report in the trust's Annual Report to Shareholders, for the fiscal year ended February 28, 1999, are incorporated by reference (are legally a part of this SAI). For a free copy of the current prospectus or annual report, contact your investment representative or call 1-800/DIAL BEN (1-800/342-5236). CONTENTS Goals and Strategies ....................2 Risks ...................................7 Officers and Trustees ..................10 Management and Other Services ..........13 Portfolio Transactions .................14 Distributions and Taxes ................14 Organization, Voting Rights and Principal Holders .................16 Buying and Selling Shares ..............17 Pricing Shares .........................22 The Underwriter ........................23 Performance ............................25 Miscellaneous Information ..............28 Description of Ratings .................29 State Tax Treatment ....................31 - ------------------------------------------------------------------------------ MUTUAL FUNDS, ANNUITIES, AND OTHER INVESTMENT PRODUCTS: o ARE NOT FEDERALLY INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY OF THE U.S. GOVERNMENT; o ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED BY, ANY BANK; o ARE SUBJECT TO INVESTMENT RISKS, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. - ------------------------------------------------------------------------------ GOALS AND STRATEGIES - ------------------------------------------------------------------------------- Each fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. Each state fund also tries to provide a maximum level of income exempt from personal income taxes, if any, for resident shareholders of the fund's state. These goals are fundamental, which means they may not be changed without shareholder approval. Of course, there is no assurance that any fund will meet its goal. As fundamental policies, each fund normally invests at least 80% of its net assets in securities that pay interest free from federal income taxes, including the federal alternative minimum tax and, in the case of each state fund, at least 80% of its net assets in securities that pay interest free from the personal income taxes, if any, of its state. As a nonfundamental policy, each state fund also normally invests at least 65% of its total assets in municipal securities of its state. Unlike the state funds, the Franklin Insured Tax-Free Income Fund is diversified nationally and will not invest more than 25% of its total assets in the municipal securities of any one state or territory. Municipal securities issued by a fund's state or that state's counties, municipalities, authorities, agencies, or other subdivisions, as well as municipal securities issued by U.S. territories such as Guam, Puerto Rico, or the Mariana Islands, generally pay interest free from federal income tax and from state personal income taxes, if any, for residents of the fund's state. Each fund tries to invest all of its assets in tax-free municipal securities. The issuer's bond counsel generally gives the issuer an opinion on the tax-exempt status of a municipal security when the security is issued. Some states may require a fund to invest a certain amount of its assets in securities of that state, or in securities that are otherwise tax-free under the laws of that state, in order for any portion of the fund's distributions to be free from the state's personal income taxes. If a fund's state requires this, the fund will try to invest its assets as required so that its distributions will be free from personal income taxes for resident shareholder's of the fund's state. Below is a description of various types of municipal and other securities that each fund may buy. Other types of municipal securities may become available that are similar to those described below and in which each fund also may invest, if consistent with its investment goals and policies. TAX ANTICIPATION NOTES are issued to finance short-term working capital needs of municipalities in anticipation of various seasonal tax revenues, which will be used to pay the notes. They are usually general obligations of the issuer, secured by the taxing power for the payment of principal and interest. REVENUE ANTICIPATION NOTES are similar to tax anticipation notes except they are issued in expectation of the receipt of other kinds of revenue, such as federal revenues available under the Federal Revenue Sharing Program. BOND ANTICIPATION NOTES are normally issued to provide interim financing until long-term financing can be arranged. Proceeds from long-term bond issues then provide the money for the repayment of the notes. TAX-EXEMPT COMMERCIAL PAPER typically represents a short-term obligation (270 days or less) issued by a municipality to meet working capital needs. MUNICIPAL BONDS meet longer-term capital needs and generally have maturities from one to 30 years when issued. They have two principal classifications: general obligation bonds and revenue bonds. GENERAL OBLIGATION BONDS. Issuers of general obligation bonds include states, counties, cities, towns and regional districts. The proceeds of these obligations are used to fund a wide range of public projects, including construction or improvement of schools, highways and roads. The basic security behind general obligation bonds is the issuer's pledge of its full faith, credit and taxing power for the payment of principal and interest. The taxes that can be levied for the payment of debt service may be limited or unlimited as to the rate or amount of special assessments. REVENUE BONDS. The full faith, credit and taxing power of the issuer do not secure revenue bonds. Instead, the principal security for a revenue bond is generally the net revenue derived from a particular facility, group of facilities, or, in some cases, the proceeds of a special excise tax or other specific revenue source. Revenue bonds are issued to finance a wide variety of capital projects, including: electric, gas, water and sewer systems; highways, bridges and tunnels; port and airport facilities; colleges and universities; and hospitals. The principal security behind these bonds may vary. For example, housing finance authorities have a wide range of security, including partially or fully insured mortgages, rent subsidized and/or collateralized mortgages, and/or the net revenues from housing or other public projects. Many bonds provide additional security in the form of a debt service reserve fund that may be used to make principal and interest payments. Some authorities have further security in the form of state assurances (although without obligation) to make up deficiencies in the debt service reserve fund. TAX-EXEMPT INDUSTRIAL DEVELOPMENT REVENUE BONDS are issued by or on behalf of public authorities to finance various privately operated facilities for business, manufacturing, housing, sports and pollution control, as well as public facilities such as airports, mass transit systems, ports and parking. The payment of principal and interest is solely dependent on the ability of the facility's user to meet its financial obligations and the pledge, if any, of the facility or other property as security for payment. VARIABLE OR FLOATING RATE SECURITIES Each fund may invest in top rated variable or floating rate securities, including variable rate demand notes, which have interest rates that change either at specific intervals (variable rate), from daily up to monthly, or whenever a benchmark rate changes (floating rate). The interest rate adjustments are designed to help stabilize the security's price. While this feature helps protect against a decline in the security's market price when interest rates go up, it lowers the fund's income when interest rates fall. Variable or floating rate securities may include a demand feature, which may be unconditional. The demand feature allows the holder to demand prepayment of the principal amount before maturity, generally on one to 30 days' notice. The holder receives the principal amount plus any accrued interest either from the issuer or by drawing on a bank letter of credit, a guarantee or insurance issued with respect to the security. Each fund generally uses variable or floating rate securities as short-term investments while waiting for long-term investment opportunities. MUNICIPAL LEASE OBLIGATIONS Each fund may invest in municipal lease obligations, including certificates of participation. Municipal lease obligations generally finance the purchase of public property. The property is leased to the state or a local government, and the lease payments are used to pay the interest on the obligations. Municipal lease obligations differ from other municipal securities because the lessee's governing body must appropriate (set aside) the money to make the lease payments each year. If the money is not appropriated, the issuer or the lessee can end the lease without penalty. If the lease is cancelled, investors who own the municipal lease obligations may not be paid. The board of trustees reviews each fund's municipal lease obligations to try to assure that they are liquid investments based on various factors reviewed by the fund's manager and monitored by the board. These factors may include (a) the credit quality of the obligations and the extent to which they are rated or, if unrated, comply with existing criteria and procedures followed to ensure that they are comparable in quality to the ratings required for the fund to invest, including an assessment of the likelihood of the lease being canceled, taking into account how essential the leased property is and the term of the lease compared to the useful life of the leased property; (b) the size of the municipal securities market, both in general and with respect to municipal lease obligations; and (c) the extent to which the type of municipal lease obligations held by the fund trade on the same basis and with the same degree of dealer participation as other municipal securities of comparable credit rating or quality. Since annual appropriations are required to make lease payments, municipal lease obligations generally are not subject to constitutional limitations on the issuance of debt and may allow an issuer to increase government liabilities beyond constitutional debt limits. When faced with increasingly tight budgets, local governments have more discretion to curtail lease payments under a municipal lease obligation than they do to curtail payments on other municipal securities. If not enough money is appropriated to make the lease payments, the leased property may be repossessed as security for holders of the municipal lease obligations. If this happens, there is no assurance that the property's private sector or re-leasing value will be enough to make all outstanding payments on the municipal lease obligations or that the payments will continue to be tax-free. While cancellation risk is inherent to municipal lease obligations, each fund believes that this risk may be reduced, although not eliminated, by its policies on the quality of securities in which it may invest. CALLABLE BONDS Each fund may invest in callable bonds, which allow the issuer to repay some or all of the bonds ahead of schedule. If a bond is called, the fund will receive the principal amount, the accrued interest, and may receive a small additional payment as a call premium. The manager may sell a callable bond before its call date, if it believes the bond is at its maximum premium potential. When pricing callable bonds, the call feature is factored into the price of the bonds and may impact the fund's net asset value. An issuer is more likely to call its bonds when interest rates are falling, because the issuer can issue new bonds with lower interest payments. If a bond is called, the fund may have to replace it with a lower-yielding security. A call of some or all of these securities may lower a fund's income and its distributions to shareholders. If the fund originally paid a premium for the bond because it had appreciated in value from its original issue price, the fund also may not be able to recover the full amount it paid for the bond. One way for the fund to protect itself from call risk is to buy bonds with call protection. Call protection is an assurance that the bond will not be called for a specific time period, typically five to 10 years from when the bond is issued. ESCROW-SECURED OR DEFEASED BONDS are created when an issuer refunds, before maturity, an outstanding bond issue that is not immediately callable (or pre-refunds), and sets aside funds for redemption of the bonds at a future date. The issuer uses the proceeds from a new bond issue to buy high grade, interest bearing debt securities, generally direct obligations of the U.S. government. These securities are then deposited in an irrevocable escrow account held by a trustee bank to secure all future payments of principal and interest on the pre-refunded bond. Escrow-secured bonds often receive a triple A or equivalent rating. STRIPPED MUNICIPAL SECURITIES Municipal securities may be sold in "stripped" form. Stripped municipal securities represent separate ownership of principal and interest payments on municipal securities. ZERO-COUPON SECURITIES Each fund may invest in zero-coupon and delayed interest securities. Zero-coupon securities make no periodic interest payments, but are sold at a deep discount from their face value. The buyer recognizes a rate of return determined by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. The discount varies depending on the time remaining until maturity, as well as market interest rates, liquidity of the security, and the issuer's perceived credit quality. The discount, in the absence of financial difficulties of the issuer, typically decreases as the final maturity date approaches. If the issuer defaults, the fund may not receive any return on its investment. Because zero-coupon securities bear no interest and compound semiannually at the rate fixed at the time of issuance, their value is generally more volatile than the value of other fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zero-coupon securities fall more dramatically than bonds paying interest on a current basis when interest rates rise. When interest rates fall, zero-coupon securities rise more rapidly in value, because the bonds reflect a fixed rate of return. An investment in zero-coupon and delayed interest securities may cause a fund to recognize income and make distributions to shareholders before it receives any cash payments on its investment. To generate cash to satisfy distribution requirements, a fund may have to sell portfolio securities that it otherwise would have continued to hold or to use cash flows from other sources such as the sale of fund shares. CONVERTIBLE AND STEP COUPON BONDS Each fund may invest a portion of its assets in convertible and step coupon bonds. Convertible bonds are zero-coupon securities until a predetermined date, at which time they convert to a specified coupon security. The coupon on step coupon bonds changes periodically during the life of the security based on predetermined dates chosen when the security is issued. U.S. GOVERNMENT OBLIGATIONS are issued by the U.S. Treasury or by agencies and instrumentalities of the U.S. government and are backed by the full faith and credit of the U.S. government. They include Treasury bills, notes and bonds. COMMERCIAL PAPER is a promissory note issued by a corporation to finance its short-term credit needs. Each fund may invest in taxable commercial paper only for temporary defensive purposes. WHEN-ISSUED TRANSACTIONS Municipal securities are frequently offered on a "when-issued" basis. When so offered, the price, which is generally expressed in yield terms, is fixed at the time the commitment to buy is made, but delivery and payment take place at a later date. During the time between purchase and settlement, no payment is made by the fund to the issuer and no interest accrues to the fund. If the other party to the transaction fails to deliver or pay for the security, the fund could miss a favorable price or yield opportunity, or could experience a loss. When a fund makes the commitment to buy a municipal security on a when-issued basis, it records the transaction and reflects the value of the security in the determination of its net asset value. The funds believe their net asset value or income will not be negatively affected by their purchase of municipal securities on a when-issued basis. The funds will not engage in when-issued transactions for investment leverage purposes. Although a fund will generally buy municipal securities on a when-issued basis with the intention of acquiring the securities, it may sell the securities before the settlement date if it is considered advisable. When a fund is the buyer, it will maintain cash or liquid securities, with an aggregate value equal to the amount of its purchase commitments, in a segregated account with its custodian bank until payment is made. If assets of a fund are held in cash pending the settlement of a purchase of securities, the fund will not earn income on those assets. ILLIQUID INVESTMENTS Each fund may invest up to 10% of its net assets in illiquid securities. Illiquid securities are generally securities that cannot be sold within seven days in the normal course of business at approximately the amount at which the fund has valued them. DIVERSIFICATION All of the funds, except the Arizona and Florida Funds, are diversified funds. The Arizona and Florida Funds are non-diversified. As a fundamental policy, none of the diversified funds will buy a security if, with respect to 75% of its net assets, more than 5% would be in the securities of any single issuer (with the exception of obligations of the U.S. government). For this purpose, each political subdivision, agency, or instrumentality, each multi-state agency of which a state is a member, and each public authority that issues private activity bonds on behalf of a private entity, is considered a separate issuer. Escrow-secured or defeased bonds are not generally considered an obligation of the original municipality when determining diversification. Each fund, including the Arizona and Florida Funds, intends to meet certain diversification requirements for tax purposes. Generally, to meet federal tax requirements at the close of each quarter, a fund may not invest more than 25% of its total assets in any one issuer and, with respect to 50% of total assets, may not invest more than 5% of its total assets in any one issuer. These limitations do not apply to U.S. government securities and may be revised if applicable federal income tax requirements are revised. TEMPORARY INVESTMENTS When the manager believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist, including the unavailability of securities that meet a fund's investment criteria, it may invest each fund's portfolio in a temporary defensive manner. Under these circumstances, each fund may invest all of its assets in securities that pay taxable interest, including (i) high quality commercial paper; (ii) securities issued or guaranteed by the full faith and credit of the U.S. government; or (iii) for the state funds, municipal securities issued by a state or local government other than the fund's state. Each fund also may invest all of its assets in municipal securities issued by a U.S. territory such as Guam, Puerto Rico or the Mariana Islands. SECURITIES TRANSACTIONS The frequency of portfolio transactions, usually referred to as the portfolio turnover rate, varies for each fund from year to year, depending on market conditions. While short-term trading increases portfolio turnover and may increase costs, the execution costs for municipal securities are substantially less than for equivalent dollar values of equity securities. CREDIT QUALITY All things being equal, the lower a security's credit quality, the higher the risk and the higher the yield the security generally must pay as compensation to investors for the higher risk. A security's credit quality depends on the issuer's ability to pay interest on the security and, ultimately, to repay the principal. Independent rating agencies, such as Fitch Investors Service Inc. (Fitch), Moody's Investors Service, Inc. (Moody's), and Standard & Poor's Corporation (S&P), often rate municipal securities based on their opinion of the issuer's credit quality. Most rating agencies use a descending alphabet scale to rate long-term securities, and a descending numerical scale to rate short-term securities. These ratings are described at the end of this SAI under "Description of Ratings." An insurance company, bank or other foreign or domestic entity may provide credit support for a municipal security and enhance its credit quality. For example, some municipal securities are insured, which means they are covered by an insurance policy that guarantees the timely payment of principal and interest. Other municipal securities may be backed by letters of credit, guarantees, or escrow or trust accounts that contain securities backed by the full faith and credit of the U.S. government to secure the payment of principal and interest. As discussed in the prospectus, each fund has limitations on the credit quality of the securities it may buy. These limitations are generally applied when a fund makes an investment so that a fund is not required to sell a security because of a later change in circumstances. INSURANCE Each fund invests primarily in insured municipal securities. Normally, the underlying rating of an insured security is one of the top three ratings of Fitch, Moody's or S&P. An insurer may insure municipal securities that are rated below the top three ratings or that are unrated if the securities otherwise meet the insurer's quality standards. A fund will only enter into a contract to buy an insured municipal security if either permanent insurance or an irrevocable commitment to insure the municipal security by a qualified municipal bond insurer is in place. The insurance feature guarantees the scheduled payment of principal and interest, but does not guarantee (i) the market value of the insured municipal security, (ii) the value of a fund's shares, or (iii) a fund's distributions. TYPES OF INSURANCE. There are three types of insurance: new issue, secondary and portfolio. A new issue insurance policy is purchased by the issuer when the security is issued. A secondary insurance policy may be purchased by the fund after a security is issued. With both new issue and secondary policies, the insurance continues in force for the life of the security and, thus, may increase the credit rating of the security, as well as its resale value. Each fund may buy a secondary insurance policy at any time, if the manager believes the insurance would be in the best interest of the fund. A fund is likely to buy a secondary insurance policy if, in the manager's opinion, the fund could sell a security at a price that exceeds the current value of the security, without insurance, plus the cost of the insurance. The purchase of a secondary policy, if available, may enable the fund to sell a defaulted security at a price similar to that of comparable securities that are not in default. The fund would value a defaulted security covered by a secondary insurance policy at its market value. Each fund also may buy a portfolio insurance policy. Unlike new issue and secondary insurance, which continue in force for the life of the security, portfolio insurance only covers securities while they are held by the fund. If the fund sells a security covered by portfolio insurance, the insurance protection on that security ends and, thus, cannot affect the resale value of the security. As a result, the fund may continue to hold any security insured under a portfolio insurance policy that is in default or in significant risk of default and, absent any unusual or unforeseen circumstances as a result of the portfolio insurance policy, would likely value the defaulted security, or security for which there is a significant risk of default, at the same price as comparable securities that are not in default. While a defaulted security is held in the fund's portfolio, the fund continues to pay the insurance premium on the security but also collects interest payments from the insurer and retains the right to collect the full amount of principal from the insurer when the security comes due. The insurance premium the fund pays for a portfolio insurance policy is a fund expense. The premium is payable monthly and is adjusted for purchases and sales of covered securities during the month. If the fund fails to pay its premium, the insurer may take action against the fund to recover any premium payments that are due. The insurer may not change premium rates for securities covered by a portfolio insurance policy, regardless of the issuer's ability or willingness to meet its obligations. QUALIFIED MUNICIPAL BOND INSURERS. Insurance policies may be issued by any one of several qualified municipal bond insurers. Each fund generally buys insured municipal securities only if they are secured by an insurance policy issued by an insurer whose claims paying ability is rated triple A or its equivalent by Fitch, Moody's or S&P. Currently, there are four primary, triple A rated municipal bond insurers. Each fund, however, may invest a portion of its assets in insured municipal securities covered by policies issued by insurers with a rating below tripe A or its equivalent. The bond insurance industry is a regulated industry. All bond insurers must be licensed in each state in order to write financial guarantees in that jurisdiction. Regulations vary from state to state. Most regulators, however, require minimum standards of solvency and limitations on leverage and investment of assets. Regulators also place restrictions on the amount an insurer can guarantee in relation to the insurer's capital base. Neither the funds nor the manager makes any representations as to the ability of any insurance company to meet its obligation to a fund if called upon to do so. Currently, to the best of our knowledge, there are no securities in the funds' portfolios on which an insurer is paying the principal or interest otherwise payable by the issuer of the bond. If an insurer is called upon to pay the principal or interest on an insured security that is due for payment but that has not been paid by the issuer, the terms of payment would be governed by the provisions of the insurance policy. After payment, the insurer becomes the owner of the security, appurtenant coupon, or right to payment of principal or interest on the security and is fully subrogated to all of the fund's rights with respect to the security, including the right to payment. The insurer's rights to the security or to payment of principal or interest are limited, however, to the amount the insurer has paid. INVESTMENT RESTRICTIONS Each fund has adopted the following restrictions as fundamental policies. This means they may only be changed if the change is approved by (i) more than 50% of the fund's outstanding shares or (ii) 67% or more of the fund's shares present at a shareholder meeting if more than 50% of the fund's outstanding shares are represented at the meeting in person or by proxy, whichever is less. Each fund may not: 1. Borrow money or mortgage or pledge any of its assets, except that borrowings (and a pledge of assets therefore) for temporary or emergency purposes may be made from banks in any amount up to 5% of the total asset value. 2. Buy any securities on "margin" or sell any securities "short," except that it may use such short-term credits as are necessary for the clearance of transactions. 3. Make loans, except through the purchase of readily marketable debt securities which are either publicly distributed or customarily purchased by institutional investors. Although such loans are not presently intended, this prohibition will not preclude the fund from loaning portfolio securities to broker-dealers or other institutional investors if at least 102% cash collateral is pledged and maintained by the borrower; provided such portfolio security loans may not be made if, as a result, the aggregate of such loans exceeds 10% of the value of the fund's total assets at the time of the most recent loan. 4. Act as underwriter of securities issued by other persons, except insofar as the fund may be technically deemed an underwriter under the federal securities laws in connection with the disposition of portfolio securities. 5. Purchase the securities of any issuer which would result in owning more than 10% of the voting securities of such issuer, except with respect to the Arizona and Florida Funds, each of which will not purchase a security, if as a result: i) more than 25% of its total assets would be invested in the securities of a single issuer or ii) with respect to 50% of its total assets, more than 5% of its assets would be invested in the securities of a single issuer. 6. Purchase securities from or sell to the trust's officers and trustees, or any firm of which any officer or trustee is a member, as principal, or retain securities of any issuer if, to the knowledge of the trust, one or more of the trust's officers, trustees, or investment manager own beneficially more than one-half of 1% of the securities of such issuer and all such officers and trustees together own beneficially more than 5% of such securities. 7. Acquire, lease or hold real estate, except such as may be necessary or advisable for the maintenance of its offices and provided that this limitation shall not prohibit the purchase of municipal and other debt securities secured by real estate or interests therein. 8. Invest in commodities and commodity contracts, puts, calls, straddles, spreads or any combination thereof, or interests in oil, gas, or other mineral exploration or development programs, except that it may purchase, hold and dispose of "obligations with puts attached" in accordance with its investment policies. 9. Invest in companies for the purpose of exercising control or management. 10. Purchase securities of other investment companies, except in connection with a merger, consolidation, acquisition or reorganization, except to the extent permitted by exemptions which may be granted under the Investment Company Act of 1940, which allows the fund to invest in shares of one or more investment companies, of the type generally referred to as money market funds, managed by Franklin Advisers, Inc. or its affiliates. 11. In the case of the Arizona and Florida Funds, purchase securities, in private placements or in other transactions, for which there are legal or contractual restrictions on resale. 12. Invest more than 25% of its assets in securities of any industry; although for purposes of this limitation, tax-exempt securities and U.S. government obligations are not considered to be part of any industry. If a bankruptcy or other extraordinary event occurs concerning a particular security the fund owns, the fund may receive stock, real estate, or other investments that the fund would not, or could not, buy. If this happens, the fund intends to sell such investments as soon as practicable while maximizing the return to shareholders. Generally, the policies and restrictions discussed in this SAI and in the prospectus apply when the fund makes an investment. In most cases, the fund is not required to sell a security because circumstances change and the security no longer meets one or more of the fund's policies or restrictions. If a percentage restriction or limitation is met at the time of investment, a later increase or decrease in the percentage due to a change in the value or liquidity of portfolio securities will not be considered a violation of the restriction or limitation. RISKS - ------------------------------------------------------------------------------- STATE Since each state fund mainly invests in the municipal securities of its state, its performance is closely tied to the ability of issuers of municipal securities in its state to continue to make principal and interest payments on their securities. The issuers' ability to do this is in turn dependent on economic, political and other conditions within the state. Below is a discussion of certain conditions that may affect municipal issuers in the funds' various states. It is not a complete analysis of every material fact that may affect the ability of issuers of municipal securities to meet their debt obligations or the economic or political conditions within any state and is subject to change. The information below is based on data available to the funds from historically reliable sources, but the funds have not independently verified it. The ability of issuers of municipal securities to continue to make principal and interest payments is dependent in large part on their ability to raise revenues, primarily through taxes, and to control spending. Many factors can affect a state's revenues including the rate of population growth, unemployment rates, personal income growth, federal aid, and the ability to attract and keep successful businesses. A number of factors can also affect a state's spending including current debt levels, and the existence of accumulated budget deficits. The following provides some information on these and other factors. ARIZONA. Strong overall employment growth, affordable housing, and an attractive climate have helped Arizona's population grow at a rate four times faster than the national rate during the 1990s. Although population growth is expected to remain strong in the near term, the rate of growth has slowed since 1996 as a result of California's economic recovery and thus less migration from that state. Competitive wage rates, low energy costs, corporate tax reductions and an abundance of land also have helped to attract businesses to the state. As a result, Arizona's unemployment in 1998 was at its lowest level since the early 1970s. Arizona's economy has continued to diversify, especially in the manufacturing and services areas. As of August 1998, manufacturing accounted for approximately 10.5% of the state's total employment, trade 24.3%, services 30.4%, government 16.1%, and construction 6.6%. Farming and mining accounted for less than 2% of the total workforce. Improved diversification may help reduce the state's economic vulnerability that in the past resulted from Arizona's historical dependence on its farming, mining and real estate industries. Arizona may be vulnerable, however, to events affecting high-technology products and to recent and future economic problems in Asia. Approximately 80% of the state's exports have been in the area of high-technology products and Asian exports have supported at least 100,000 jobs in the state. Under its constitution, Arizona cannot issue general obligation debt. Thus, gross state debt levels have remained moderate. The state historically has relied on lease obligations, revenue bonds, and pay-as-you-go financing for its capital needs. Arizona's strong economic growth and higher-than-anticipated tax revenues have allowed the state to post four consecutive operating surpluses and general fund balance increases. Preliminary 1998 results show another operating surplus. During fiscal 1999, however, a reduction in the general fund balance is expected with the implementation of new school capital funding legislation. FLORIDA. Florida's population has grown rapidly in recent years, with the fastest growth among 5-17 year-olds and seniors 65 and over. The rapid growth among these age groups has required increased expenditures for services such as schools and health care and has placed sustained pressure on the state's budget for the funding of these services. As a result, Florida is more vulnerable to increases in the cost of education, Medicaid and other health care services than many other states. While the population of the young and old has grown rapidly, the working age population has grown at a much slower rate and is expected to decline in the coming years. Because of its substantial retirement age population, investment income and transfer payments, such as social security and pension benefits, made up more than 44% of Florida's income distribution in 1997. Wages and salaries were more than 49%. This income mix historically has led to relatively stable personal income levels across different economic cycles, although it also has created some vulnerability to changes in the consumer price index at the federal level. Florida's tax base has been relatively narrow, with no personal income tax and 60% of its revenues derived from the state's sales and use tax. This reliance on a cyclical revenue source has created some vulnerability to recession and slower growth in the tax base. Recent trends also have shown an increase in internet and mail order sales, which the state has not been able to tax. If this trend continues, states that rely on sales taxes, like Florida, could be adversely affected. To help provide some protection against the historically volatile nature of the sales tax, Florida enacted a constitutional amendment creating a budget stabilization fund. As of March 1999, Florida projected a balance in the fund of $787 million by the end of fiscal 1999. Over the past five years, Florida's debt burden has grown dramatically with the increased need for schools and health care, as well as environmental protection programs designed to help protect the state's important tourism industry. The state's rapidly growing population should continue to place demands on the state's budget and debt burden to finance infrastructure and other improvements. While tourism has remained Florida's most important industry, Florida's economy has continued to diversify from a narrow base of agriculture and seasonal tourism into a service and trade economy. Job growth has been steady, slightly higher than the national average, and unemployment has been around the national rate. Because of its location, much of the state's export sector has relied on exports to Latin America. Although exports have comprised a relatively small part of the gross state product, the sector's dependence on Latin America poses a risk in the event of economic instability in that region. MASSACHUSETTS. In recent years, Massachusetts' economy has been strong and has led the northeast region. Since 1996, total employment gains in the commonwealth have exceeded national levels. Likewise, the commonwealth's unemployment rates have compared favorably with national rates. In June 1998, the unemployment rate in Massachusetts was 3.4%, compared to the national rate of 4.5%. Employment growth of 3% in 1998, together with low unemployment rates and modest population growth, have begun to cause some concerns of a tight labor market. A labor shortage may be a potential constraint on the further growth of Massachusetts' economy. Although the economy has been strong, the commonwealth's debt levels have remained among the highest in the nation. Spending disciplines imposed during the state's severe financial difficulties in the early 1990s have helped and have resulted in seven consecutive years of balanced financial operations. At the same time, the state has greatly reduced its reliance on temporary borrowing. While the state has regained some control over its budget, continuing expenditure pressures may present fiscal challenges. After a period of restrained debt issuance, pressure to increase borrowing has been building. Funding for routine infrastructure needs and a costly tunnel project have been the focus of this pressure. Tax cuts, a relatively high unfunded pension liability, and the substantial reliance of localities on the commonwealth for financial assistance also may strain the commonwealth's resources and limit its financial flexibility. With the rate of economic growth expected to slow in coming years, Massachusetts' biggest challenge is likely to be the long term management of its capital and debt plans. MICHIGAN. While Michigan's economy has diversified to some degree, it has remained dependent on its durable goods manufacturing sector, especially on its cyclical auto industry. In recent years, manufacturing has accounted for 22% of the state's employment and 33% of personal income. While this sector has been strong since the end of the national recession in the early 1990s and has made improvements that could potentially lessen its historical volatility, the state's reliance on manufacturing has made its economy potentially more volatile than the economies of more diverse states and more susceptible to the adverse effects of another recession. Since 1992, Michigan's economy has grown at a healthy pace. Unemployment levels have been below national levels since 1994 and, through September 1998, employment levels were at an all-time high. With the help of its strong economy, Michigan's finances also have improved. Tighter budget controls and the positive effect on revenues of the state's relatively strong economy have allowed the state to replenish reserves, which had been severely depleted during the early 1990s. The state's budget stabilization fund was at more than $1 billion at September 30, 1998. Michigan may need the increased stability these reserve levels provide to offset higher school funding requirements. The state also has been able to maintain its traditionally low debt levels, although contingent debt levels issued through school programs and based on the state's credit have grown rapidly, approaching levels almost double the state's outstanding direct debt. The state's contingent debt exposure will need to be carefully managed in the coming years to help maintain the state's financial stability. MINNESOTA. Minnesota's economy has been well diversified, with only some concentration in the manufacturing sector. Historically, this diversification has allowed the state to perform well during economic cycles, compared with the rest of the nation. The effects of the last national recession were less severe in Minnesota, and the state was able to recover more quickly than many other states. Since late 1994, Minnesota has experienced steady job growth, especially in the services sector. Much of this growth has occurred in the Minneapolis-St. Paul metropolitan area and has created labor shortages in some industries. These shortages have in turn resulted in higher-than-average wage levels. Higher wages, together with a tight labor market, could limit future job expansion in the state. Strong financial management, healthy reserve levels and a moderate debt burden have allowed the state to maintain its strong credit rating. With the recent strength of its economy and growth in revenues, Minnesota has increased its general fund balance to $2.4 billion as of June 30, 1998, with a budgetary reserve of $1.4 billion. With its balances and reserves at historic levels, several tax cuts have been proposed. OHIO. Ohio's financial performance has been strong, aided recently by the continuing diversification of the state's economy. Although manufacturing has remained a large part of the economy, the state's overall employment mix has moved more in line with that of the nation, improving the state's economic stability. Nonetheless, the state's reliance on manufacturing creates vulnerability to recession and potential financial volatility. The state's sizable financial reserves, however, may lend some stability and help protect the state against future spending pressures and economic cycles. In recent years, Ohio's employment growth has slowed to below the national average. For the year ended September 1998, job growth was 1.2%, compared to 2.4% for the nation. Much of this growth has been concentrated in the services and construction sectors. Unemployment was 4.3% in September 1998, slightly below the national rate. The state's population growth also has been slow and, during 1997, was the slowest in the Great Lakes region. Ohio's direct debt levels have been moderate. As a result, debt service payments on its general obligation debt and lease obligations have been manageable. The state has enjoyed large operating surpluses over the last seven fiscal years, which have allowed the state to restore its reserves to levels above those before the last recession. A recent court decision requiring major changes to the state's school funding programs, however, may create some pressure on the state's ability to maintain a balanced budget, especially in the event of an economic slowdown. U.S. TERRITORIES Since each fund may invest a portion of its assets in municipal securities issued by U.S. territories, the ability of municipal issuers in U.S. territories to continue to make principal and interest payments also may affect a fund's performance. As with state municipal issuers, the ability to make these payments is dependent on economic, political and other conditions. Below is a discussion of certain conditions within some of the territories where the funds may be invested. It is not a complete analysis of every material fact that may affect the ability of issuers of U.S. territory municipal securities to meet their debt obligations or the economic or political conditions within the territories and is subject to change. It is based on data available to the funds from historically reliable sources, but it has not been independently verified by the funds. GUAM. Guam's economy has been heavily dependent on tourism. It has been especially dependent on Japanese tourism, which has made Guam vulnerable to fluctuations in the relationship between the U.S. dollar and the Japanese yen. The recent Asian economic crisis and Typhoon Paka, which hit Guam in December 1997, negatively affected both tourism and other economic activities in Guam and contributed to a decline of 1.8% in gross island product between 1997 and 1998. In the early to mid-1990s, Guam's financial position deteriorated due to a series of natural disasters that led to increased spending on top of already significant budget gaps. As a result, the government introduced a comprehensive financial plan in June 1995 to help balance the budget and reduce the general fund deficit by fiscal 1999. For fiscal 1998, however, Guam incurred a $21 million deficit and ended the year with a negative unreserved general fund balance of $158.9 million. Another deficit is expected in 1999. While Guam's debt burden has been manageable, Guam's ability to maintain current debt levels may be challenged in the near future. U.S. military downsizing has reduced the federal presence on the island and also may reduce federal support for infrastructure projects. At the same time, Guam has faced increasing pressure to improve its infrastructure to help generate economic development. Overall, as of May 1999, S&P's outlook for Guam was negative due to Guam's continued weak financial position and inability to meet the goals of the financial plan. MARIANA ISLANDS. The Mariana Islands became a commonwealth in 1975. At that time, the U.S. government agreed to exempt the islands from federal minimum wage and immigration laws in an effort to help stimulate industry and the economy. The islands' minimum wage has been more than $2 per hour below the U.S. level and tens of thousands of workers have immigrated from various Asian countries to provide cheap labor for the islands' industries. Recently, the islands' tourism and apparel industries combined to help increase gross business receipts from $224 million in 1985 to $2 billion in 1996. PUERTO RICO. Overall, Moody's considered Puerto Rico's outlook stable as of January 1999. In recent years, Puerto Rico's financial performance has improved. Relatively strong revenue growth and more aggressive tax collection procedures resulted in a general fund surplus for fiscal 1998 (unaudited). For fiscal 1999, spending increases of 11% are budgeted, which may create an operating deficit and deplete the commonwealth's unreserved fund balance. Puerto Rico's debt levels have been high. Going forward, these levels may increase as Puerto Rico attempts to finance significant capital and infrastructure improvements. Puerto Rico also will need to address its large unfunded pension liability of more than $6 billion. Despite Puerto Rico's stable outlook, Puerto Rico may face challenges in the coming years with the 1996 passage of a bill eliminating section 936 of the Internal Revenue Code. This section has given certain U.S. corporations operating in Puerto Rico significant tax advantages. These incentives have helped considerably with Puerto Rico's economic growth, especially with the development of its manufacturing sector. U.S. firms that have benefited from these incentives have provided a significant portion of Puerto Rico's revenues, employment and deposits in local financial institutions. The section 936 incentives will be phased out over a 10-year period ending in 2006. It is hoped that this long phase-out period will give Puerto Rico sufficient time to lessen the potentially negative effects of section 936's elimination. Outstanding issues relating to the potential for a transition to statehood also may have broad implications for Puerto Rico and its financial and credit position. OFFICERS AND TRUSTEES - ------------------------------------------------------------------------------- The trust has a board of trustees. The board is responsible for the overall management of the trust, including general supervision and review of each fund's investment activities. The board, in turn, elects the officers of the trust who are responsible for administering the trust's day-to-day operations. The board also monitors each fund to ensure no material conflicts exist among share classes. While none is expected, the board will act appropriately to resolve any material conflict that may arise. The name, age and address of the officers and board members, as well as their affiliations, positions held with the trust, and principal occupations during the past five years are shown below. Frank H. Abbott, III (78) 1045 Sansome Street, San Francisco, CA 94111 TRUSTEE President and Director, Abbott Corporation (an investment company); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, MotherLode Gold Mines Consolidated (gold mining) and Vacu-Dry Co. (food processing). Harris J. Ashton (67) 191 Clapboard Ridge Road, Greenwich, CT 06830 TRUSTEE Director, RBC Holdings, Inc. (bank holding company) and Bar-S Foods (meat packing company); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, President, Chief Executive Officer and Chairman of the Board, General Host Corporation (nursery and craft centers). S. Joseph Fortunato (66) Park Avenue at Morris County, P.O. Box 1945 Morristown, NJ 07962-1945 TRUSTEE Member of the law firm of Pitney, Hardin, Kipp & Szuch; director or trustee, as the case may be, of 50 of the investment companies in the Franklin Templeton Group of Funds. Edith E. Holiday (47) 3239 38th Street, N.W., Washington, DC 20016 TRUSTEE Director, Amerada Hess Corporation (exploration and refining of natural gas) (1993-present), Hercules Incorporated (chemicals, fibers and resins) (1993-present), Beverly Enterprises, Inc. (health care) (1995-present) and H.J. Heinz Company (processed foods and allied products) (1994-present); director or trustee, as the case may be, of 24 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman (1995-1997) and Trustee (1993-1997), National Child Research Center, Assistant to the President of the United States and Secretary of the Cabinet (1990-1993), General Counsel to the United States Treasury Department (1989-1990), and Counselor to the Secretary and Assistant Secretary for Public Affairs and Public Liaison-United States Treasury Department (1988-1989). *Charles B. Johnson (66) 777 Mariners Island Blvd., San Mateo, CA 94404 CHAIRMAN OF THE BOARD AND TRUSTEE President, Chief Executive Officer and Director, Franklin Resources, Inc.; Chairman of the Board and Director, Franklin Advisers, Inc., Franklin Investment Advisory Services, Inc. and Franklin Templeton Distributors, Inc.; Director, Franklin/Templeton Investor Services, Inc. and Franklin Templeton Services, Inc.; officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 49 of the investment companies in the Franklin Templeton Group of Funds. *Rupert H. Johnson, Jr. (58) 777 Mariners Island Blvd., San Mateo, CA 94404 PRESIDENT AND TRUSTEE Executive Vice President and Director, Franklin Resources, Inc. and Franklin Templeton Distributors, Inc.; President and Director, Franklin Advisers, Inc. and Franklin Investment Advisory Services, Inc.; Senior Vice President, Franklin Advisory Services, LLC; Director, Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Frank W.T. LaHaye (70) 20833 Stevens Creek Blvd., Suite 102, Cupertino, CA 95014 TRUSTEE General Partner, Miller & LaHaye, which is the General Partner of Peregrine Ventures II (venture capital firm); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, Fischer Imaging Corporation (medical imaging systems), Digital Transmission Systems, Inc. (wireless communications) and Quarterdeck Corporation (software firm), and General Partner, Peregrine Associates, which was the General Partner of Peregrine Ventures (venture capital firm). Gordon S. Macklin (71) 8212 Burning Tree Road, Bethesda, MD 20817 TRUSTEE Director, Fund American Enterprises Holdings, Inc. (holding company), Martek Biosciences Corporation, MCI WorldCom (information services), MedImmune, Inc. (biotechnology), Spacehab, Inc. (aerospace services) and Real 3D (software); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman, White River Corporation (financial services) and Hambrecht and Quist Group (investment banking), and President, National Association of Securities Dealers, Inc. Harmon E. Burns (54) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President and Director, Franklin Resources, Inc., Franklin Templeton Distributors, Inc. and Franklin Templeton Services, Inc.; Executive Vice President, Franklin Advisers, Inc.; Director, Franklin Investment Advisory Services, Inc. and Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Martin L. Flanagan (39) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Senior Vice President and Chief Financial Officer, Franklin Resources, Inc., Franklin/Templeton Investor Services, Inc. and Franklin Mutual Advisers, LLC; Executive Vice President, Chief Financial Officer and Director, Templeton Worldwide, Inc.; Executive Vice President, Chief Operating Officer and Director, Templeton Investment Counsel, Inc.; Executive Vice President and Chief Financial Officer, Franklin Advisers, Inc.; Chief Financial Officer, Franklin Advisory Services, LLC and Franklin Investment Advisory Services, Inc.; President and Director, Franklin Templeton Services, Inc.; officer and/or director of some of the other subsidiaries of Franklin Resources, Inc.; and officer and/or director or trustee, as the case may be, of 52 of the investment companies in the Franklin Templeton Group of Funds. Deborah R. Gatzek (50) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND SECRETARY Senior Vice President and General Counsel, Franklin Resources, Inc.; Senior Vice President, Franklin Templeton Services, Inc. and Franklin Templeton Distributors, Inc.; Executive Vice President, Franklin Advisers, Inc.; Vice President, Franklin Advisory Services, LLC and Franklin Mutual Advisers, LLC; Vice President, Chief Legal Officer and Chief Operating Officer, Franklin Investment Advisory Services, Inc.; and officer of 53 of the investment companies in the Franklin Templeton Group of Funds. Thomas J. Kenny (36) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President, Franklin Advisers, Inc.; and officer of eight of the investment companies in the Franklin Templeton Group of Funds. Diomedes Loo-Tam (60) 777 Mariners Island Blvd., San Mateo, CA 94404 TREASURER AND PRINCIPAL ACCOUNTING OFFICER Senior Vice President, Franklin Templeton Services, Inc.; and officer of 32 of the investment companies in the Franklin Templeton Group of Funds. Edward V. McVey (61) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Senior Vice President and National Sales Manager, Franklin Templeton Distributors, Inc.; and officer of 28 of the investment companies in the Franklin Templeton Group of Funds. *This board member is considered an "interested person" under federal securities laws. Note: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers The trust pays noninterested board members $1,450 per month plus $1,300 per meeting attended. Board members who serve on the audit committee of the trust and other funds in the Franklin Templeton Group of Funds receive a flat fee of $2,000 per committee meeting attended, a portion of which is allocated to the trust. Members of a committee are not compensated for any committee meeting held on the day of a board meeting. Noninterested board members also may serve as directors or trustees of other funds in the Franklin Templeton Group of Funds and may receive fees from these funds for their services. The fees payable to noninterested board members by the trust are subject to reductions resulting from fee caps limiting the amount of fees payable to board members who serve on other boards within the Franklin Templeton Group of Funds. The following table provides the total fees paid to noninterested board members by the trust and by the Franklin Templeton Group of Funds. NUMBER OF BOARDS IN TOTAL FEES THE FRANKLIN RECEIVED FROM TEMPLETON TOTAL FEES THE FRANKLIN GROUP RECEIVED TEMPLETON OF FUNDS FROM GROUP ON WHICH NAME THE TRUST($) 1 OF FUNDS($) 2 EACH SERVES 3 - ------------------------------------------------------------------------------- Frank H. Abbott, III 25,675 159,051 27 Harris J. Ashton 26,390 361,157 48 S. Joseph Fortunato 25,097 367,835 50 Edith E. Holiday 28,650 211,400 24 Frank W.T. LaHaye 26,975 163,753 27 Gordon S. Macklin 26,390 361,157 48 1. For the fiscal year ended February 28, 1999. During the period from March 1, 1998, through May 31, 1998, fees at the rate of $1,300 per month plus $1,300 per board meeting attended were in effect. 2. For the calendar year ended December 31, 1998. 3. We base the number of boards on the number of registered investment companies in the Franklin Templeton Group of Funds. This number does not include the total number of series or funds within each investment company for which the board members are responsible. The Franklin Templeton Group of Funds currently includes 54 registered investment companies, with approximately 163 U.S. based funds or series. Noninterested board members are reimbursed for expenses incurred in connection with attending board meetings, paid pro rata by each fund in the Franklin Templeton Group of Funds for which they serve as director or trustee. No officer or board member received any other compensation, including pension or retirement benefits, directly or indirectly from the fund or other funds in the Franklin Templeton Group of Funds. Certain officers or board members who are shareholders of Franklin Resources, Inc. may be deemed to receive indirect remuneration by virtue of their participation, if any, in the fees paid to its subsidiaries. Board members historically have followed a policy of having substantial investments in one or more of the funds in the Franklin Templeton Group of Funds, as is consistent with their individual financial goals. In February 1998, this policy was formalized through adoption of a requirement that each board member invest one-third of fees received for serving as a director or trustee of a Templeton fund in shares of one or more Templeton funds and one-third of fees received for serving as a director or trustee of a Franklin fund in shares of one or more Franklin funds until the value of such investments equals or exceeds five times the annual fees paid such board member. Investments in the name of family members or entities controlled by a board member constitute fund holdings of such board member for purposes of this policy, and a three year phase-in period applies to such investment requirements for newly elected board members. In implementing such policy, a board member's fund holdings existing on February 27, 1998, are valued as of such date with subsequent investments valued at cost. MANAGEMENT AND OTHER SERVICES - ------------------------------------------------------------------------------- MANAGER AND SERVICES PROVIDED Each fund's manager is Franklin Advisers, Inc. The manager is a wholly owned subsidiary of Franklin Resources, Inc. (Resources), a publicly owned company engaged in the financial services industry through its subsidiaries. Charles B. Johnson and Rupert H. Johnson, Jr. are the principal shareholders of Resources. The manager provides investment research and portfolio management services, and selects the securities for each fund to buy, hold or sell. The manager's extensive research activities include, as appropriate, traveling to meet with issuers and to review project sites. The manager also selects the brokers who execute the funds' portfolio transactions. The manager provides periodic reports to the board, which reviews and supervises the manager's investment activities. To protect the funds, the manager and its officers, directors and employees are covered by fidelity insurance. The manager and its affiliates manage numerous other investment companies and accounts. The manager may give advice and take action with respect to any of the other funds it manages, or for its own account, that may differ from action taken by the manager on behalf of each fund. Similarly, with respect to each fund, the manager is not obligated to recommend, buy or sell, or to refrain from recommending, buying or selling any security that the manager and access persons, as defined by applicable federal securities laws, may buy or sell for its or their own account or for the accounts of any other fund. The manager is not obligated to refrain from investing in securities held by the funds or other funds it manages. Of course, any transactions for the accounts of the manager and other access persons will be made in compliance with the funds' code of ethics. Under the funds' code of ethics, employees of the Franklin Templeton Group who are access persons may engage in personal securities transactions subject to the following general restrictions and procedures: (i) the trade must receive advance clearance from a compliance officer and must be completed by the close of the business day following the day clearance is granted; (ii) copies of all brokerage confirmations and statements must be sent to a compliance officer; (iii) all brokerage accounts must be disclosed on an annual basis; and (iv) access persons involved in preparing and making investment decisions must, in addition to (i), (ii) and (iii) above, file annual reports of their securities holdings each January and inform the compliance officer (or other designated personnel) if they own a security that is being considered for a fund or other client transaction or if they are recommending a security in which they have an ownership interest for purchase or sale by a fund or other client. MANAGEMENT FEES Each fund pays the manager a fee equal to a monthly rate of: o 5/96 of 1% of the value of its net assets up to and including $100 million; and o 1/24 of 1% of the value of its net assets over $100 million up to and including $250 million; and o 9/240 of 1% of the value of its net assets in excess of $250 million. The fee is computed at the close of business on the last business day of each month according to the terms of the management agreement. Each class of a fund's shares pays its proportionate share of the fee. For the last three fiscal years ended February 28, the funds paid the following management fees: MANAGEMENT FEES PAID ($) ------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------- Arizona Fun 1 129,625 53,600 9,209 Florida Fund 2 279,543 164,237 126,611 Insured Fund 8,186,468 7,894,099 7,848,890 Massachusetts Fund 1,842,232 1,792,766 1,649,833 Michigan Fund 5,623,372 5,414,427 5,284,581 Minnesota Fund 2,591,321 2,465,946 2,439,817 Ohio Fund 3,822,228 3,586,169 3,391,314 1. For the fiscal years ended February 28, 1999, 1998 and 1997, management fees, before any advance waiver, totaled $444,848, $300,020 and $238,269, respectively. Under an agreement by the manager to limit its fees, the fund paid the management fees shown. 2. For the fiscal years ended February 28, 1999, 1998 and 1997, management fees, before any advance waiver, totaled $697,080, $559,377 and $447,534, respectively. Under an agreement the manager to limit its fees, the fund paid the management fees shown. ADMINISTRATOR AND SERVICES PROVIDED Franklin Templeton Services, Inc. (FT Services) has an agreement with the manager to provide certain administrative services and facilities for each fund. FT Services is wholly owned by Resources and is an affiliate of the funds' manager and principal underwriter. The administrative services FT Services provides include preparing and maintaining books, records, and tax and financial reports, and monitoring compliance with regulatory requirements. ADMINISTRATION FEES The manager pays FT Services a monthly fee equal to an annual rate of: o 0.15% of each fund's average daily net assets up to $200 million; o 0.135% of average daily net assets over $200 million up to $700 million; o 0.10% of average daily net assets over $700 million up to $1.2 billion; and o 0.075% of average daily net assets over $1.2 billion. During the last three fiscal years ended February 28, the manager paid FT Services the following administration fees: ADMINISTRATION FEES PAID ($) ---------------------------- 1999 1998 1997 1 - ------------------------------------------------------------------------------- Arizona Fund 101,043 70,517 23,726 Florida Fund 169,903 132,554 46,588 Insured Fund 1,895,252 1,847,411 767,504 Massachusetts Fund 506,241 492,589 190,575 Michigan Fund 1,465,757 1,420,284 584,545 Minnesota Fund 730,139 693,518 286,923 Ohio Fund 1,066,391 1,013,556 410,345 1. For the period from October 1, 1996, through February 28, 1997. SHAREHOLDER SERVICING AND TRANSFER AGENT Franklin/Templeton Investor Services, Inc. (Investor Services) is each fund's shareholder servicing agent and acts as the fund's transfer agent and dividend-paying agent. Investor Services is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Please send all correspondence to Investor Services to P.O. Box 997151, Sacramento, CA 95899-9983. For its services, Investor Services receives a fixed fee per account. Each fund also will reimburse Investor Services for certain out-of-pocket expenses, which may include payments by Investor Services to entities, including affiliated entities, that provide sub-shareholder services, recordkeeping and/or transfer agency services to beneficial owners of the fund. The amount of reimbursements for these services per benefit plan participant fund account per year will not exceed the per account fee payable by a fund to Investor Services in connection with maintaining shareholder accounts. CUSTODIAN Bank of New York, Mutual Funds Division, 90 Washington Street, New York, NY 10286, acts as custodian of each fund's securities and other assets. AUDITOR PricewaterhouseCoopers LLP, 333 Market Street, San Francisco, CA 94105, is the funds' independent auditor. The auditor gives an opinion on the financial statements included in the trust's Annual Report to Shareholders and reviews the trust's registration statement filed with the U.S. Securities and Exchange Commission (SEC). PORTFOLIO TRANSACTIONS - ------------------------------------------------------------------------------- Since most purchases by the funds are principal transactions at net prices, the funds incur little or no brokerage costs. Each fund deals directly with the selling or buying principal or market maker without incurring charges for the services of a broker on its behalf, unless it is determined that a better price or execution may be obtained by using the services of a broker. Purchases of portfolio securities from underwriters will include a commission or concession paid by the issuer to the underwriter, and purchases from dealers will include a spread between the bid and ask prices. As a general rule, the funds do not buy securities in underwritings where they are given no choice, or only limited choice, in the designation of dealers to receive the commission. The funds seek to obtain prompt execution of orders at the most favorable net price. Transactions may be directed to dealers in return for research and statistical information, as well as for special services provided by the dealers in the execution of orders. It is not possible to place a dollar value on the special executions or on the research services the manager receives from dealers effecting transactions in portfolio securities. The allocation of transactions in order to obtain additional research services allows the manager to supplement its own research and analysis activities and to receive the views and information of individuals and research staffs of other securities firms. As long as it is lawful and appropriate to do so, the manager and its affiliates may use this research and data in their investment advisory capacities with other clients. If the funds' officers are satisfied that the best execution is obtained, the sale of fund shares, as well as shares of other funds in the Franklin Templeton Group of Funds, also may be considered a factor in the selection of broker-dealers to execute the funds' portfolio transactions. If purchases or sales of securities of the funds and one or more other investment companies or clients supervised by the manager are considered at or about the same time, transactions in these securities will be allocated among the several investment companies and clients in a manner deemed equitable to all by the manager, taking into account the respective sizes of the funds and the amount of securities to be purchased or sold. In some cases this procedure could have a detrimental effect on the price or volume of the security so far as the funds are concerned. In other cases it is possible that the ability to participate in volume transactions may improve execution and reduce transaction costs to the funds. During the fiscal years ended February 28, 1999, 1998 and 1997, the funds did not pay any brokerage commissions. As of February 28, 1999, the funds did not own securities of their regular broker-dealers. DISTRIBUTIONS AND TAXES - ------------------------------------------------------------------------------- The funds calculate dividends and capital gains the same way for each class. The amount of any income dividends per share will differ, however, generally due to the difference in the distribution and service (Rule 12b-1) fees of each class. The funds do not pay "interest" or guarantee any fixed rate of return on an investment in their shares. DISTRIBUTIONS OF NET INVESTMENT INCOME Each fund receives income generally in the form of interest on its investments. This income, less expenses incurred in the operation of the fund, constitutes the fund's net investment income from which dividends may be paid to you. By meeting certain requirements of the Internal Revenue Code, the funds have qualified and continue to qualify to pay exempt-interest dividends to you. These dividends are derived from interest income exempt from regular federal income tax, and are not subject to regular federal income tax when they are distributed to you. In addition, to the extent that exempt-interest dividends are derived from interest on obligations of a state or its political subdivisions, or from interest on qualifying U.S. territorial obligations (including qualifying obligations of Puerto Rico, the U.S. Virgin Islands or Guam), they also will be exempt from that state's personal income taxes. Most states generally do not grant tax-free treatment to interest on state and municipal securities of other states. The funds may earn taxable income on any temporary investments, on the discount from stripped obligations or their coupons, on income from securities loans or other taxable transactions, or on ordinary income derived from the sale of market discount bonds. Any fund distributions from such income will be taxable to you as ordinary income, whether you receive them in cash or in additional shares. DISTRIBUTIONS OF CAPITAL GAINS The funds may derive capital gains and losses in connection with sales or other dispositions of their portfolio securities. Distributions from net short-term capital gains will be taxable to you as ordinary income. Distributions from net long-term capital gains will be taxable to you as long-term capital gain, regardless of how long you have held your shares in a fund. Any net capital gains realized by a fund generally will be distributed once each year, and may be distributed more frequently, if necessary, in order to reduce or eliminate excise or income taxes on the fund. INFORMATION ON THE TAX CHARACTER OF DISTRIBUTIONS The funds will inform you of the amount of your ordinary income dividends and capital gains distributions at the time they are paid, and will advise you of their tax status for federal income tax purposes shortly after the close of each calendar year, including the portion of the distributions that on average comprise taxable income or interest income that is a tax preference item under the alternative minimum tax. If you have not held fund shares for a full year, a fund may designate and distribute to you, as taxable, tax-exempt or tax preference income, a percentage of income that is not equal to the actual amount of such income earned during the period of your investment in the fund. ELECTION TO BE TAXED AS A REGULATED INVESTMENT COMPANY Each fund has elected to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code, has qualified as such for its most recent fiscal year, and intends to so qualify during the current fiscal year. As regulated investment companies, the funds generally pay no federal income tax on the income and gains they distribute to you. The board reserves the right not to maintain the qualification of a fund as a regulated investment company if it determines such course of action to be beneficial to shareholders. In such case, a fund will be subject to federal, and possibly state, corporate taxes on its taxable income and gains, and distributions to you will be taxed as ordinary dividend income to the extent of the fund's earnings and profits. EXCISE TAX DISTRIBUTION REQUIREMENTS To avoid federal excise taxes, the Internal Revenue Code requires each fund to distribute to you by December 31 of each year, at a minimum, the following amounts: 98% of its taxable ordinary income earned during the calendar year; 98% of its capital gain net income earned during the twelve month period ending October 31; and 100% of any undistributed amounts from the prior year. Each fund intends to declare and pay these amounts in December (or in January that are treated by you as received in December) to avoid these excise taxes, but can give no assurances that its distributions will be sufficient to eliminate all taxes. REDEMPTION OF FUND SHARES Redemptions and exchanges of fund shares are taxable transactions for federal and state income tax purposes. If you redeem your fund shares, or exchange your fund shares for shares of a different Franklin Templeton Fund, the IRS will require that you report a gain or loss on your redemption or exchange. If you hold your shares as a capital asset, the gain or loss that you realize will be capital gain or loss and will be long-term or short-term, generally depending on how long you hold your shares. Any loss incurred on the redemption or exchange of shares held for six months or less will be disallowed to the extent of any exempt-interest dividends distributed to you with respect to your fund shares and any remaining loss will be treated as a long-term capital loss to the extent of any long-term capital gains distributed to you by the fund on those shares. All or a portion of any loss that you realize upon the redemption of your fund shares will be disallowed to the extent that you buy other shares in the fund (through reinvestment of dividends or otherwise) within 30 days before or after your share redemption. Any loss disallowed under these rules will be added to your tax basis in the new shares you buy. DEFERRAL OF BASIS If you redeem some or all of your shares in a fund, and then reinvest the sales proceeds in the fund or in another Franklin Templeton Fund within 90 days of buying the original shares, the sales charge that would otherwise apply to your reinvestment may be reduced or eliminated. The IRS will require you to report gain or loss on the redemption of your original shares in a fund. In doing so, all or a portion of the sales charge that you paid for your original shares in a fund will be excluded from your tax basis in the shares sold (for the purpose of determining gain or loss upon the sale of such shares). The portion of the sales charge excluded will equal the amount that the sales charge is reduced on your reinvestment. Any portion of the sales charge excluded from your tax basis in the shares sold will be added to the tax basis of the shares you acquire from your reinvestment. DIVIDENDS-RECEIVED DEDUCTION FOR CORPORATIONS Because each fund's income consists of interest rather than dividends, no portion of its distributions generally will be eligible for the corporate dividends-received deduction. None of the dividends paid by the funds for the most recent fiscal year qualified for such deduction, and it is anticipated that none of the current year's dividends will so qualify. INVESTMENT IN COMPLEX SECURITIES Each fund may invest in complex securities. These investments may be subject to numerous special and complex tax rules. These rules could affect whether gains and losses recognized by a fund are treated as ordinary income or capital gain, accelerate the recognition of income to a fund and/or defer a fund's ability to recognize losses. In turn, these rules may affect the amount, timing or character of the income distributed to you by a fund. TREATMENT OF PRIVATE ACTIVITY BOND INTEREST Interest on certain private activity bonds, while still exempt from regular federal income tax, is a preference item for taxpayers when determining their alternative minimum tax under the Internal Revenue Code and under the income tax provisions of several states. Private activity bond interest could subject you to or increase your liability under federal and state alternative minimum taxes, depending on your individual or corporate tax position. Persons who are defined in the Internal Revenue Code as substantial users (or persons related to such users) of facilities financed by private activity bonds should consult with their tax advisors before buying fund shares. ORGANIZATION, VOTING RIGHTS AND PRINCIPAL HOLDERS - ------------------------------------------------------------------------------- Each fund is a series of Franklin Tax-Free Trust, an open-end management investment company, commonly called a mutual fund. The trust was organized as a Massachusetts business trust in September 1984, and is registered with the SEC. As a shareholder of a Massachusetts business trust, you could, under certain circumstances, be held personally liable as a partner for its obligations. The Agreement and Declaration of Trust, however, contains an express disclaimer of shareholder liability for acts or obligations of the fund. The Declaration of Trust also provides for indemnification and reimbursement of expenses out of the fund's assets if you are held personally liable for obligations of the fund. The Declaration of Trust provides that each fund shall, upon request, assume the defense of any claim made against you for any act or obligation of the fund and satisfy any judgment thereon. All such rights are limited to the assets of the fund. The Declaration of Trust further provides that the fund may maintain appropriate insurance (for example, fidelity bonding and errors and omissions insurance) for the protection of the fund, its shareholders, trustees, officers, employees and agents to cover possible tort and other liabilities. Furthermore, the activities of the fund as an investment company, as distinguished from an operating company, would not likely give rise to liabilities in excess of the fund's total assets. Thus, the risk that you would incur financial loss on account of shareholder liability is limited to the unlikely circumstance in which both inadequate insurance exists and the fund itself is unable to meet its obligations. Each fund, except the Arizona and Florida Funds, currently offers two classes of shares, Class A and Class C. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. The full title of each class is: o Franklin Insured Tax-Free Income Fund - Class A o Franklin Insured Tax-Free Income Fund - Class C o Franklin Massachusetts Insured Tax-Free Income Fund - Class A o Franklin Massachusetts Insured Tax-Free Income Fund - Class C o Franklin Michigan Insured Tax-Free Income Fund - Class A o Franklin Michigan Insured Tax-Free Income Fund - Class C o Franklin Minnesota Insured Tax-Free Income Fund - Class A o Franklin Minnesota Insured Tax-Free Income Fund - Class C o Franklin Ohio Insured Tax-Free Income Fund - Class A o Franklin Ohio Insured Tax-Free Income Fund - Class C The Arizona and Florida Funds each offer only one share class. Because their sales charge structures and Rule 12b-1 plans are similar to those of Class A shares, shares of the Arizona and Florida Funds are considered Class A shares for redemption, exchange and other purposes. The funds may offer additional classes of shares in the future. Shares of each class represent proportionate interests in the fund's assets. On matters that affect the fund as a whole, each class has the same voting and other rights and preferences as any other class. On matters that affect only one class, only shareholders of that class may vote. Each class votes separately on matters affecting only that class, or expressly required to be voted on separately by state or federal law. Shares of each class of a series have the same voting and other rights and preferences as the other classes and series of the trust for matters that affect the trust as a whole. Additional series may be offered in the future. The trust has noncumulative voting rights. For board member elections, this gives holders of more than 50% of the shares voting the ability to elect all of the members of the board. If this happens, holders of the remaining shares voting will not be able to elect anyone to the board. The trust does not intend to hold annual shareholder meetings. The trust or a series of the trust may hold special meetings, however, for matters requiring shareholder approval. A meeting may be called by the board to consider the removal of a board member if requested in writing by shareholders holding at least 10% of the outstanding shares. In certain circumstances, we are required to help you communicate with other shareholders about the removal of a board member. A special meeting also may be called by the board in its discretion. From time to time, the number of fund shares held in the "street name" accounts of various securities dealers for the benefit of their clients or in centralized securities depositories may exceed 5% of the total shares outstanding. To the best knowledge of the fund, no other person holds beneficially or of record more than 5% of the outstanding shares of any class. As of April 12, 1999, the officers and board members, as a group, owned of record and beneficially less than 1% of the outstanding shares of each fund and class. The board members may own shares in other funds in the Franklin Templeton Group of Funds. BUYING AND SELLING SHARES - ------------------------------------------------------------------------------- The fund continuously offers its shares through securities dealers who have an agreement with Franklin Templeton Distributors, Inc. (Distributors). A securities dealer includes any financial institution that, either directly or through affiliates, has an agreement with Distributors to handle customer orders and accounts with the fund. This reference is for convenience only and does not indicate a legal conclusion of capacity. Banks and financial institutions that sell shares of the fund may be required by state law to register as securities dealers. For investors outside the U.S., the offering of fund shares may be limited in many jurisdictions. An investor who wishes to buy shares of the fund should determine, or have a broker-dealer determine, the applicable laws and regulations of the relevant jurisdiction. Investors are responsible for compliance with tax, currency exchange or other regulations applicable to redemption and purchase transactions in any jurisdiction to which they may be subject. Investors should consult appropriate tax and legal advisors to obtain information on the rules applicable to these transactions. All checks, drafts, wires and other payment mediums used to buy or sell shares of the fund must be denominated in U.S. dollars. We may, in our sole discretion, either (a) reject any order to buy or sell shares denominated in any other currency or (b) honor the transaction or make adjustments to your account for the transaction as of a date and with a foreign currency exchange factor determined by the drawee bank. When you buy shares, if you submit a check or a draft that is returned unpaid to the fund we may impose a $10 charge against your account for each returned item. INITIAL SALES CHARGES The maximum initial sales charge is 4.25% for Class A and 1% for Class C. The initial sales charge for Class A shares may be reduced for certain large purchases, as described in the prospectus. We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases. The Franklin Templeton Funds include the U.S. registered mutual funds in the Franklin Group of Funds(R) and the Templeton Group of Funds except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. CUMULATIVE QUANTITY DISCOUNT. For purposes of calculating the sales charge on Class A shares, you may combine the amount of your current purchase with the cost or current value, whichever is higher, of your existing shares in the Franklin Templeton Funds. You also may combine the shares of your spouse, children under the age of 21 or grandchildren under the age of 21. If you are the sole owner of a company, you also may add any company accounts, including retirement plan accounts. LETTER OF INTENT (LOI). You may buy Class A shares at a reduced sales charge by completing the letter of intent section of your account application. A letter of intent is a commitment by you to invest a specified dollar amount during a 13 month period. The amount you agree to invest determines the sales charge you pay. By completing the letter of intent section of the application, you acknowledge and agree to the following: o You authorize Distributors to reserve 5% of your total intended purchase in Class A shares registered in your name until you fulfill your LOI. Your periodic statements will include the reserved shares in the total shares you own, and we will pay or reinvest dividend and capital gain distributions on the reserved shares according to the distribution option you have chosen. o You give Distributors a security interest in the reserved shares and appoint Distributors as attorney-in-fact. o Distributors may sell any or all of the reserved shares to cover any additional sales charge if you do not fulfill the terms of the LOI. o Although you may exchange your shares, you may not sell reserved shares until you complete the LOI or pay the higher sales charge. After you file your LOI with a fund, you may buy Class A shares at the sales charge applicable to the amount specified in your LOI. Sales charge reductions based on purchases in more than one Franklin Templeton Fund will be effective only after notification to Distributors that the investment qualifies for a discount. Any Class A purchases you made within 90 days before you filed your LOI also may qualify for a retroactive reduction in the sales charge. If you file your LOI with the fund before a change in the fund's sales charge, you may complete the LOI at the lower of the new sales charge or the sales charge in effect when the LOI was filed. Your holdings in the Franklin Templeton Funds acquired more than 90 days before you filed your LOI will be counted towards the completion of the LOI, but they will not be entitled to a retroactive reduction in the sales charge. Any redemptions you make during the 13 month period will be subtracted from the amount of the purchases for purposes of determining whether the terms of the LOI have been completed. If the terms of your LOI are met, the reserved shares will be deposited to an account in your name or delivered to you or as you direct. If the amount of your total purchases, less redemptions, is more than the amount specified in your LOI and is an amount that would qualify for a further sales charge reduction, a retroactive price adjustment will be made by Distributors and the securities dealer through whom purchases were made. The price adjustment will be made on purchases made within 90 days before and on those made after you filed your LOI and will be applied towards the purchase of additional shares at the offering price applicable to a single purchase or the dollar amount of the total purchases. If the amount of your total purchases, less redemptions, is less than the amount specified in your LOI, the sales charge will be adjusted upward, depending on the actual amount purchased (less redemptions) during the period. You will need to send Distributors an amount equal to the difference in the actual dollar amount of sales charge paid and the amount of sales charge that would have applied to the total purchases if the total of the purchases had been made at one time. Upon payment of this amount, the reserved shares held for your account will be deposited to an account in your name or delivered to you or as you direct. If within 20 days after written request the difference in sales charge is not paid, we will redeem an appropriate number of reserved shares to realize the difference. If you redeem the total amount in your account before you fulfill your LOI, we will deduct the additional sales charge due from the sale proceeds and forward the balance to you. GROUP PURCHASES. If you are a member of a qualified group, you may buy Class A shares at a reduced sales charge that applies to the group as a whole. The sales charge is based on the combined dollar value of the group members' existing investments, plus the amount of the current purchase. A qualified group is one that: o Was formed at least six months ago, o Has a purpose other than buying fund shares at a discount, o Has more than 10 members, o Can arrange for meetings between our representatives and group members, o Agrees to include Franklin Templeton Fund sales and other materials in publications and mailings to its members at reduced or no cost to Distributors, o Agrees to arrange for payroll deduction or other bulk transmission of investments to the fund, and o Meets other uniform criteria that allow Distributors to achieve cost savings in distributing shares. WAIVERS FOR INVESTMENTS FROM CERTAIN PAYMENTS. Class A shares may be purchased without an initial sales charge or contingent deferred sales charge (CDSC) by investors who reinvest within 365 days: o Dividend and capital gain distributions from any Franklin Templeton Fund. The distributions generally must be reinvested in the same share class. Certain exceptions apply, however, to Class C shareholders who chose to reinvest their distributions in Class A shares of the fund before November 17, 1997, and to Advisor Class or Class Z shareholders of a Franklin Templeton Fund who may reinvest their distributions in the fund's Class A shares. This waiver category also applies to Class C shares. o Dividend or capital gain distributions from a real estate investment trust (REIT) sponsored or advised by Franklin Properties, Inc. o Annuity payments received under either an annuity option or from death benefit proceeds, if the annuity contract offers as an investment option the Franklin Valuemark Funds or the Templeton Variable Products Series Fund. You should contact your tax advisor for information on any tax consequences that may apply. o Redemption proceeds from a repurchase of shares of Franklin Floating Rate Trust, if the shares were continuously held for at least 12 months. If you immediately placed your redemption proceeds in a Franklin Bank CD or a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date the CD matures, including any rollover, or the date you redeem your money fund shares. o Redemption proceeds from the sale of Class A shares of any of the Templeton Global Strategy Funds if you are a qualified investor. If you paid a CDSC when you redeemed your Class A shares from a Templeton Global Strategy Fund, a new CDSC will apply to your purchase of fund shares and the CDSC holding period will begin again. We will, however, credit your fund account with additional shares based on the CDSC you previously paid and the amount of the redemption proceeds that you reinvest. If you immediately placed your redemption proceeds in a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date they are redeemed from the money fund. WAIVERS FOR CERTAIN INVESTORS. Class A shares also may be purchased without an initial sales charge or CDSC by various individuals and institutions due to anticipated economies in sales efforts and expenses, including: o Trust companies and bank trust departments agreeing to invest in Franklin Templeton Funds over a 13 month period at least $1 million of assets held in a fiduciary, agency, advisory, custodial or similar capacity and over which the trust companies and bank trust departments or other plan fiduciaries or participants, in the case of certain retirement plans, have full or shared investment discretion. We will accept orders for these accounts by mail accompanied by a check or by telephone or other means of electronic data transfer directly from the bank or trust company, with payment by federal funds received by the close of business on the next business day following the order. o Any state or local government or any instrumentality, department, authority or agency thereof that has determined the fund is a legally permissible investment and that can only buy fund shares without paying sales charges. Please consult your legal and investment advisors to determine if an investment in the fund is permissible and suitable for you and the effect, if any, of payments by the fund on arbitrage rebate calculations. o Broker-dealers, registered investment advisors or certified financial planners who have entered into an agreement with Distributors for clients participating in comprehensive fee programs o Qualified registered investment advisors who buy through a broker-dealer or service agent who has entered into an agreement with Distributors o Registered securities dealers and their affiliates, for their investment accounts only o Current employees of securities dealers and their affiliates and their family members, as allowed by the internal policies of their employer o Officers, trustees, directors and full-time employees of the Franklin Templeton Funds or the Franklin Templeton Group, and their family members, consistent with our then-current policies o Any investor who is currently a Class Z shareholder of Franklin Mutual Series Fund Inc. (Mutual Series), or who is a former Mutual Series Class Z shareholder who had an account in any Mutual Series fund on October 31, 1996, or who sold his or her shares of Mutual Series Class Z within the past 365 days o Investment companies exchanging shares or selling assets pursuant to a merger, acquisition or exchange offer o Accounts managed by the Franklin Templeton Group o Certain unit investment trusts and their holders reinvesting distributions from the trusts SALES IN TAIWAN. Under agreements with certain banks in Taiwan, Republic of China, each fund's shares are available to these banks' trust accounts without a sales charge. The banks may charge service fees to their customers who participate in the trusts. A portion of these service fees may be paid to Distributors or one of its affiliates to help defray expenses of maintaining a service office in Taiwan, including expenses related to local literature fulfillment and communication facilities. Each fund's Class A shares may be offered to investors in Taiwan through securities advisory firms known locally as Securities Investment Consulting Enterprises. In conformity with local business practices in Taiwan, Class A shares may be offered with the following schedule of sales charges: SIZE OF PURCHASE - U.S. DOLLARS SALES CHARGE (%) - ------------------------------------------------------------------------------- Under $30,000 3.0 $30,000 but less than $100,000 2.0 $100,000 but less than $400,000 1.0 $400,000 or more 0 DEALER COMPENSATION Securities dealers may at times receive the entire sales charge. A securities dealer who receives 90% or more of the sales charge may be deemed an underwriter under the Securities Act of 1933, as amended. Financial institutions or their affiliated brokers may receive an agency transaction fee in the percentages indicated in the dealer compensation table in the funds' prospectus. Distributors may pay the following commissions, out of its own resources, to securities dealers who initiate and are responsible for purchases of Class A shares of $1 million or more: 0.75% on sales of $1 million to $2 million, plus 0.60% on sales over $2 million to $3 million, plus 0.50% on sales over $3 million to $50 million, plus 0.25% on sales over $50 million to $100 million, plus 0.15% on sales over $100 million. These breakpoints are reset every 12 months for purposes of additional purchases. Distributors and/or its affiliates provide financial support to various securities dealers that sell shares of the Franklin Templeton Group of Funds. This support is based primarily on the amount of sales of fund shares. The amount of support may be affected by: total sales; net sales; levels of redemptions; the proportion of a securities dealer's sales and marketing efforts in the Franklin Templeton Group of Funds; a securities dealer's support of, and participation in, Distributors' marketing programs; a securities dealer's compensation programs for its registered representatives; and the extent of a securities dealer's marketing programs relating to the Franklin Templeton Group of Funds. Financial support to securities dealers may be made by payments from Distributors' resources, from Distributors' retention of underwriting concessions and, in the case of funds that have Rule 12b-1 plans, from payments to Distributors under such plans. In addition, certain securities dealers may receive brokerage commissions generated by fund portfolio transactions in accordance with the rules of the National Association of Securities Dealers, Inc. Distributors routinely sponsors due diligence meetings for registered representatives during which they receive updates on various Franklin Templeton Funds and are afforded the opportunity to speak with portfolio managers. Invitation to these meetings is not conditioned on selling a specific number of shares. Those who have shown an interest in the Franklin Templeton Funds, however, are more likely to be considered. To the extent permitted by their firm's policies and procedures, registered representatives' expenses in attending these meetings may be covered by Distributors. CONTINGENT DEFERRED SALES CHARGE (CDSC) If you invest $1 million or more in Class A shares, either as a lump sum or through our cumulative quantity discount or letter of intent programs, a CDSC may apply on any shares you sell within 12 months of purchase. For Class C shares, a CDSC may apply if you sell your shares within 18 months of purchase. The CDSC is 1% of the value of the shares sold or the net asset value at the time of purchase, whichever is less. CDSC WAIVERS. The CDSC for any share class generally will be waived for: o Account fees o Redemptions of Class A shares by investors who purchased $1 million or more without an initial sales charge if the securities dealer of record waived its commission in connection with the purchase o Redemptions by the fund when an account falls below the minimum required account size o Redemptions following the death of the shareholder or beneficial owner o Redemptions through a systematic withdrawal plan set up before February 1, 1995 o Redemptions through a systematic withdrawal plan set up on or after February 1, 1995, up to 1% monthly, 3% quarterly, 6% semiannually or 12% annually of your account's net asset value depending on the frequency of your plan EXCHANGE PRIVILEGE If you request the exchange of the total value of your account, accrued but unpaid income dividends and capital gain distributions will be reinvested in the fund at net asset value on the date of the exchange, and then the entire share balance will be exchanged into the new fund. Backup withholding and information reporting may apply. If a substantial number of shareholders should, within a short period, sell their fund shares under the exchange privilege, the fund might have to sell portfolio securities it might otherwise hold and incur the additional costs related to such transactions. On the other hand, increased use of the exchange privilege may result in periodic large inflows of money. If this occurs, it is each fund's general policy to initially invest this money in short-term, tax-exempt municipal securities, unless it is believed that attractive investment opportunities consistent with the fund's investment goals exist immediately. This money will then be withdrawn from the short-term, tax-exempt municipal securities and invested in portfolio securities in as orderly a manner as is possible when attractive investment opportunities arise. The proceeds from the sale of shares of an investment company are generally not available until the seventh day following the sale. The funds you are seeking to exchange into may delay issuing shares pursuant to an exchange until that seventh day. The sale of fund shares to complete an exchange will be effected at net asset value at the close of business on the day the request for exchange is received in proper form. SYSTEMATIC WITHDRAWAL PLAN Our systematic withdrawal plan allows you to sell your shares and receive regular payments from your account on a monthly, quarterly, semiannual or annual basis. The value of your account must be at least $5,000 and the minimum payment amount for each withdrawal must be at least $50. There are no service charges for establishing or maintaining a systematic withdrawal plan. Once your plan is established, any distributions paid by the fund will be automatically reinvested in your account. Payments under the plan will be made from the redemption of an equivalent amount of shares in your account, generally on the 25th day of the month in which a payment is scheduled. If the 25th falls on a weekend or holiday, we will process the redemption on the next business day. When you sell your shares under a systematic withdrawal plan, it is a taxable transaction. To avoid paying sales charges on money you plan to withdraw within a short period of time, you may not want to set up a systematic withdrawal plan if you plan to buy shares on a regular basis. Shares sold under the plan also may be subject to a CDSC. Redeeming shares through a systematic withdrawal plan may reduce or exhaust the shares in your account if payments exceed distributions received from the fund. This is especially likely to occur if there is a market decline. If a withdrawal amount exceeds the value of your account, your account will be closed and the remaining balance in your account will be sent to you. Because the amount withdrawn under the plan may be more than your actual yield or income, part of the payment may be a return of your investment. You may discontinue a systematic withdrawal plan, change the amount and schedule of withdrawal payments, or suspend one payment by notifying us by mail or by phone at least seven business days before the end of the month preceding a scheduled payment. The funds may discontinue a systematic withdrawal plan by notifying you in writing and will automatically discontinue a systematic withdrawal plan if all shares in your account are withdrawn or if the fund receives notification of the shareholder's death or incapacity. REDEMPTIONS IN KIND Each fund has committed itself to pay in cash (by check) all requests for redemption by any shareholder of record, limited in amount, however, during any 90-day period to the lesser of $250,000 or 1% of the value of the fund's net assets at the beginning of the 90-day period. This commitment is irrevocable without the prior approval of the U.S. Securities and Exchange Commission (SEC). In the case of redemption requests in excess of these amounts, the board reserves the right to make payments in whole or in part in securities or other assets of the fund, in case of an emergency, or if the payment of such a redemption in cash would be detrimental to the existing shareholders of the fund. In these circumstances, the securities distributed would be valued at the price used to compute the fund's net assets and you may incur brokerage fees in converting the securities to cash. Redemptions in kind are taxable transactions. The fund does not intend to redeem illiquid securities in kind. If this happens, however, you may not be able to recover your investment in a timely manner. SHARE CERTIFICATES We will credit your shares to your fund account. We do not issue share certificates unless you specifically request them. This eliminates the costly problem of replacing lost, stolen or destroyed certificates. If a certificate is lost, stolen or destroyed, you may have to pay an insurance premium of up to 2% of the value of the certificate to replace it. Any outstanding share certificates must be returned to the fund if you want to sell or exchange those shares or if you would like to start a systematic withdrawal plan. The certificates should be properly endorsed. You can do this either by signing the back of the certificate or by completing a share assignment form. For your protection, you may prefer to complete a share assignment form and to send the certificate and assignment form in separate envelopes. GENERAL INFORMATION If dividend checks are returned to the fund marked "unable to forward" by the postal service, we will consider this a request by you to change your dividend option to reinvest all distributions. The proceeds will be reinvested in additional shares at net asset value until we receive new instructions. Distribution or redemption checks sent to you do not earn interest or any other income during the time the checks remain uncashed. Neither the funds nor their affiliates will be liable for any loss caused by your failure to cash such checks. The funds are not responsible for tracking down uncashed checks, unless a check is returned as undeliverable. In most cases, if mail is returned as undeliverable we are required to take certain steps to try to find you free of charge. If these attempts are unsuccessful, however, we may deduct the costs of any additional efforts to find you from your account. These costs may include a percentage of the account when a search company charges a percentage fee in exchange for its location services. The wiring of redemption proceeds is a special service that we make available whenever possible. By offering this service to you, the funds are not bound to meet any redemption request in less than the seven day period prescribed by law. Neither the funds nor their agents shall be liable to you or any other person if, for any reason, a redemption request by wire is not processed as described in the prospectus. Franklin Templeton Investor Services, Inc. (Investor Services) may pay certain financial institutions that maintain omnibus accounts with the funds on behalf of numerous beneficial owners for recordkeeping operations performed with respect to such owners. For each beneficial owner in the omnibus account, the fund may reimburse Investor Services an amount not to exceed the per account fee that the fund normally pays Investor Services. These financial institutions also may charge a fee for their services directly to their clients. If you buy or sell shares through your securities dealer, we use the net asset value next calculated after your securities dealer receives your request, which is promptly transmitted to the fund. If you sell shares through your securities dealer, it is your dealer's responsibility to transmit the order to the fund in a timely fashion. Your redemption proceeds will not earn interest between the time we receive the order from your dealer and the time we receive any required documents. Any loss to you resulting from your dealer's failure to transmit your redemption order to the fund in a timely fashion must be settled between you and your securities dealer. Certain shareholder servicing agents may be authorized to accept your transaction request. For institutional accounts, there may be additional methods of buying or selling fund shares than those described in this SAI or in the prospectus. In the event of disputes involving multiple claims of ownership or authority to control your account, the fund has the right (but has no obligation) to: (a) freeze the account and require the written agreement of all persons deemed by the fund to have a potential property interest in the account, before executing instructions regarding the account; (b) interplead disputed funds or accounts with a court of competent jurisdiction; or (c) surrender ownership of all or a portion of the account to the IRS in response to a notice of levy. PRICING SHARES - ------------------------------------------------------------------------------- When you buy shares, you pay the offering price. The offering price is the net asset value (NAV) per share plus any applicable sales charge, calculated to two decimal places using standard rounding criteria. When you sell shares, you receive the NAV minus any applicable CDSC. The value of a mutual fund is determined by deducting the fund's liabilities from the total assets of the portfolio. The net asset value per share is determined by dividing the net asset value of the fund by the number of shares outstanding. Each fund calculates the NAV per share of each class each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). The funds do not calculate the NAV on days the New York Stock Exchange (NYSE) is closed for trading, which include New Year's Day, Martin Luther King Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. When determining its NAV, each fund values cash and receivables at their realizable amounts, and records interest as accrued. Each fund values over-the-counter portfolio securities within the range of the most recent quoted bid and ask prices. If portfolio securities trade both in the over-the-counter market and on a stock exchange, each fund values them according to the broadest and most representative market as determined by the manager. Municipal securities generally trade in the over-the-counter market rather than on a securities exchange. In the absence of a sale or reported bid and ask prices, information with respect to bond and note transactions, quotations from bond dealers, market transactions in comparable securities, and various relationships between securities are used to determine the value of municipal securities. Generally, trading in U.S. government securities and money market instruments is substantially completed each day at various times before the close of the NYSE. The value of these securities used in computing the NAV is determined as of such times. Occasionally, events affecting the values of these securities may occur between the times at which they are determined and the close of the NYSE that will not be reflected in the computation of the NAV. If events materially affecting the values of these securities occur during this period, the securities will be valued at their fair value as determined in good faith by the board. Other securities for which market quotations are readily available are valued at the current market price, which may be obtained from a pricing service, based on a variety of factors including recent trades, institutional size trading in similar types of securities (considering yield, risk and maturity) and/or developments related to specific issues. Securities and other assets for which market prices are not readily available are valued at fair value as determined following procedures approved by the board. With the approval of the board, the funds may use a pricing service, bank or securities dealer to perform any of the above described functions. THE UNDERWRITER - ------------------------------------------------------------------------------- Franklin Templeton Distributors, Inc. (Distributors) acts as the principal underwriter in the continuous public offering of each fund's shares. Distributors is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Distributors pays the expenses of the distribution of fund shares, including advertising expenses and the costs of printing sales material and prospectuses used to offer shares to the public. Each fund pays the expenses of preparing and printing amendments to its registration statements and prospectuses (other than those necessitated by the activities of Distributors) and of sending prospectuses to existing shareholders. The table below shows the aggregate underwriting commissions Distributors received in connection with the offering of the funds' shares, the net underwriting discounts and commissions Distributors retained after allowances to dealers, and the amounts Distributors received in connection with redemptions or repurchases of shares for the last three fiscal years ended February 28: AMOUNT RECEIVED IN TOTAL AMOUNT CONNECTION WITH COMMISSIONS RETAINED BY REDEMPTIONS AND RECEIVED ($) DISTRIBUTORS ($) REPURCHASES ($) - ------------------------------------------------------------------------------- 1999 Arizona Fund 477,674 32,175 0 Florida Fund 610,778 42,251 85 Insured Fund 3,799,368 242,769 38,597 Massachusetts Fund 1,115,229 66,155 24,083 Michigan Fund 2,630,865 163,572 10,821 Minnesota Fund 1,378,166 80,608 6,400 Ohio Fund 2,308,355 146,830 15,696 1998 Arizona Fund 444,372 30,899 0 Florida Fund 643,277 42,185 0 Insured Fund 3,458,998 223,393 9,982 Massachusetts Fund 971,661 60,293 4,495 Michigan Fund 2,762,586 167,731 18,468 Minnesota Fund 1,114,812 67,354 1,216 Ohio Fund 2,325,085 145,477 6,228 1997 Arizona Fund 325,449 20,962 0 Florida Fund 471,751 30,514 0 Insured Fund 3,651,499 232,191 6,263 Massachusetts Fund 996,784 64,688 1,328 Michigan Fund 3,025,658 186,288 7,786 Minnesota Fund 1,061,069 65,580 2,804 Ohio Fund 2,389,162 144,651 9,688 Distributors may be entitled to reimbursement under the Rule 12b-1 plans, as discussed below. Except as noted, Distributors received no other compensation from the funds for acting as underwriter. DISTRIBUTION AND SERVICE (12B-1) FEES Each class has a separate distribution or "Rule 12b-1" plan. Under each plan, the fund shall pay or may reimburse Distributors or others for the expenses of activities that are primarily intended to sell shares of the class. These expenses may include, among others, distribution or service fees paid to securities dealers or others who have executed a servicing agreement with the fund, Distributors or its affiliates; a prorated portion of Distributors' overhead expenses; and the expenses of printing prospectuses and reports used for sales purposes, and preparing and distributing sales literature and advertisements. The distribution and service (12b-1) fees charged to each class are based only on the fees attributable to that particular class. THE CLASS A PLAN. Payments by the fund under the Class A plan may not exceed 0.15% per year for the Florida and Arizona Funds, and 0.10% per year for the remaining funds, of Class A's average daily net assets, payable quarterly. All distribution expenses over this amount will be borne by those who have incurred them. In implementing the Class A plan of each fund, except the Arizona and Florida Funds, the board has determined that the annual fees payable under the plan will be equal to the sum of: (i) the amount obtained by multiplying 0.10% by the average daily net assets represented by the fund's Class A shares that were acquired by investors on or after May 1, 1994, the effective date of the plan (new assets), and (ii) the amount obtained by multiplying 0.05% by the average daily net assets represented by the fund's Class A shares that were acquired before May 1, 1994 (old assets). These fees will be paid to the current securities dealer of record on the account. In addition, until such time as the maximum payment of 0.10% is reached on a yearly basis, up to an additional 0.02% will be paid to Distributors under the plan. When the fund reaches $4 billion is assets, the amount to be paid to Distributors will be reduced from 0.02% to 0.01%. The payments made to Distributors will be used by Distributors to defray other marketing expenses that have been incurred in accordance with the plan, such as advertising. The fee is a Class A expense. This means that all Class A shareholders, regardless of when they purchased their shares, will bear Rule 12b-1 expenses at the same rate. The initial rate will be at least 0.07% (0.05% plus 0.02%) of the average daily net assets of Class A and, as Class A shares are sold on or after May 1, 1994, will increase over time. Thus, as the proportion of Class A shares purchased on or after May 1, 1994, increases in relation to outstanding Class A shares, the expenses attributable to payments under the plan also will increase (but will not exceed 0.10% of average daily net assets). While this is the currently anticipated calculation for fees payable under the Class A plan, the plan permits the board to allow the fund to pay a full 0.10% on all assets at any time. The approval of the board would be required to change the calculation of the payments to be made under the Class A plan. The Class A plan for each fund, except the Arizona and Florida Funds, does not permit unreimbursed expenses incurred in a particular year to be carried over to or reimbursed in later years. THE CLASS C PLAN. Under the Class C plan, each fund pays Distributors up to 0.50% per year of the class's average daily net assets, payable quarterly, to pay Distributors or others for providing distribution and related services and bearing certain expenses. All distribution expenses over this amount will be borne by those who have incurred them. The fund also may pay a servicing fee of up to 0.15% per year of the class's average daily net assets, payable quarterly. This fee may be used to pay securities dealers or others for, among other things, helping to establish and maintain customer accounts and records, helping with requests to buy and sell shares, receiving and answering correspondence, monitoring dividend payments from the fund on behalf of customers, and similar servicing and account maintenance activities. The expenses relating to the Class C plan also are used to pay Distributors for advancing the commission costs to securities dealers with respect to the initial sale of Class C shares. THE CLASS A AND C PLANS. In addition to the payments that Distributors or others are entitled to under each plan, each plan also provides that to the extent the fund, the manager or Distributors or other parties on behalf of the fund, the manager or Distributors make payments that are deemed to be for the financing of any activity primarily intended to result in the sale of fund shares within the context of Rule 12b-1 under the Investment Company Act of 1940, as amended, then such payments shall be deemed to have been made pursuant to the plan. The terms and provisions of each plan relating to required reports, term, and approval are consistent with Rule 12b-1. In no event shall the aggregate asset-based sales charges, which include payments made under each plan, plus any other payments deemed to be made pursuant to a plan, exceed the amount permitted to be paid under the rules of the National Association of Securities Dealers, Inc. To the extent fees are for distribution or marketing functions, as distinguished from administrative servicing or agency transactions, certain banks will not be entitled to participate in the plans as a result of applicable federal law prohibiting certain banks from engaging in the distribution of mutual fund shares. These banking institutions, however, are permitted to receive fees under the plans for administrative servicing or for agency transactions. If you are a customer of a bank that is prohibited from providing these services, you would be permitted to remain a shareholder of the fund, and alternate means for continuing the servicing would be sought. In this event, changes in the services provided might occur and you might no longer be able to avail yourself of any automatic investment or other services then being provided by the bank. It is not expected that you would suffer any adverse financial consequences as a result of any of these changes. Each plan has been approved in accordance with the provisions of Rule 12b-1. The plans are renewable annually by a vote of the board, including a majority vote of the board members who are not interested persons of the fund and who have no direct or indirect financial interest in the operation of the plans, cast in person at a meeting called for that purpose. It is also required that the selection and nomination of such board members be done by the noninterested members of the fund's board. The plans and any related agreement may be terminated at any time, without penalty, by vote of a majority of the noninterested board members on not more than 60 days' written notice, by Distributors on not more than 60 days' written notice, by any act that constitutes an assignment of the management agreement with the manager or by vote of a majority of the outstanding shares of the class. The Arizona and Florida plans also may be terminated by any act that constitutes an assignment of the underwriting agreement with Distributors. Distributors or any dealer or other firm also may terminate their respective distribution or service agreement at any time upon written notice. The plans and any related agreements may not be amended to increase materially the amount to be spent for distribution expenses without approval by a majority of the outstanding shares of the class, and all material amendments to the plans or any related agreements shall be approved by a vote of the noninterested board members, cast in person at a meeting called for the purpose of voting on any such amendment. Distributors is required to report in writing to the board at least quarterly on the amounts and purpose of any payment made under the plans and any related agreements, as well as to furnish the board with such other information as may reasonably be requested in order to enable the board to make an informed determination of whether the plans should be continued. For the fiscal year ended February 28, 1999, Distributors' eligible expenditures for advertising, printing, and payments to underwriters and broker-dealers pursuant to the plans and the amounts the funds paid Distributors under the plans were: DISTRIBUTORS' AMOUNT ELIGIBLE PAID BY EXPENSES ($) THE FUND ($) - ------------------------------------------------------------- Arizona Fund 125,733 65,600 Florida Fund 199,058 111,406 Insured Fund - Class A 1,677,988 1,462,142 Insured Fund - Class C 576,359 317,040 Massachusetts Fund - Class A 394,624 296,290 Massachusetts Fund - Class C 226,351 119,178 Michigan Fund - Class A 1,202,034 1,012,546 Michigan Fund - Class C 409,772 260,992 Minnesota Fund - Class A 559,945 438,850 Minnesota Fund - Class C 156,706 94,930 Ohio Fund - Class A 799,316 673,157 Ohio Fund - Class C 339,665 222,379 PERFORMANCE - ------------------------------------------------------------------------------- Performance quotations are subject to SEC rules. These rules require the use of standardized performance quotations or, alternatively, that every non-standardized performance quotation furnished by a fund be accompanied by certain standardized performance information computed as required by the SEC. Average annual total return and current yield quotations used by the funds are based on the standardized methods of computing performance mandated by the SEC. Performance figures reflect Rule 12b-1 fees from the date of the plan's implementation. An explanation of these and other methods used by the funds to compute or express performance follows. Regardless of the method used, past performance does not guarantee future results, and is an indication of the return to shareholders only for the limited historical period used. AVERAGE ANNUAL TOTAL RETURN Average annual total return is determined by finding the average annual rates of return over the periods indicated below that would equate an initial hypothetical $1,000 investment to its ending redeemable value. The calculation assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. The quotation assumes the account was completely redeemed at the end of each period and the deduction of all applicable charges and fees. If a change is made to the sales charge structure, historical performance information will be restated to reflect the maximum initial sales charge currently in effect. When considering the average annual total return quotations, you should keep in mind that the maximum initial sales charge reflected in each quotation is a one time fee charged on all direct purchases, which will have its greatest impact during the early stages of your investment. This charge will affect actual performance less the longer you retain your investment in the funds. The average annual total returns for the indicated periods ended February 28, 1999, were: SINCE INCEPTION 1 YEAR 5 YEARS 10 YEARS INCEPTION DATE (%) (%) (%) (%) - ------------------------------------------------------------------------------- CLASS A Arizona Fund 4/30/93 1.24 5.67 - 5.91 Florida Fund 4/30/93 1.54 5.46 - 5.38 Insured Fund 4/03/85 1.20 4.95 7.11 7.97 Massachusetts Fund 4/03/85 0.89 4.91 6.89 7.30 Michigan Fund 4/03/85 1.73 5.11 7.08 7.68 Minnesota Fund 4/03/85 0.71 4.57 6.61 7.56 Ohio Fund 4/03/85 1.17 4.98 7.03 7.67 SINCE INCEPTION 1 YEAR (%) (5/1/95) (%) - ------------------------------------------------------------------------------- CLASS C Insured Fund 3.04 6.09 Massachusetts Fund 2.70 6.04 Michigan Fund 3.70 6.36 Minnesota Fund 2.57 5.53 Ohio Fund 3.03 6.25 The following SEC formula was used to calculate these figures: n P(1+T) = ERV where: P = a hypothetical initial payment of $1,000 T = average annual total return n = number of years ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of each period at the end of each period CUMULATIVE TOTAL RETURN Like average annual total return, cumulative total return assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. Cumulative total return, however, is based on the actual return for a specified period rather than on the average return over the periods indicated above. The cumulative total returns for the indicated periods ended February 28, 1999, were: SINCE INCEPTION 1 YEAR 5 YEARS 10 YEARS INCEPTION DATE (%) (%) (%) (%) - ------------------------------------------------------------------------------- CLASS A Arizona Fund 4/30/93 1.24 31.74 - 39.80 Florida Fund 4/30/93 1.54 30.47 - 35.74 Insured Fund 4/03/85 1.20 27.30 98.82 190.59 Massachusetts Fund4/03/85 0.89 27.11 94.66 166.24 Michigan Fund 4/03/85 1.73 28.32 98.24 179.98 Minnesota Fund 4/03/85 0.71 25.02 89.61 175.48 Ohio Fund 4/03/85 1.17 27.53 97.28 179.58 SINCE INCEPTION 1 YEAR (%) (5/1/95) (%) - ------------------------------------------------------------------------------- CLASS C Insured Fund 3.04 25.42 Massachusetts Fund 2.70 25.20 Michigan Fund 3.70 26.63 Minnesota Fund 2.57 22.92 Ohio Fund 3.03 26.12 CURRENT YIELD Current yield shows the income per share earned by a fund. It is calculated by dividing the net investment income per share earned during a 30-day base period by the applicable maximum offering price per share on the last day of the period and annualizing the result. Expenses accrued for the period include any fees charged to all shareholders of the class during the base period. The yields for the 30-day period ended February 28, 1999, were: CLASS A (%) CLASS C (%) - ------------------------------------------------------------------------------- Arizona Fund 3.81 - Florida Fund 3.79 - Insured Fund 3.83 3.38 Massachusetts Fund 3.75 3.33 Michigan Fund 3.71 3.28 Minnesota Fund 3.83 3.41 Ohio Fund 3.84 3.42 The following SEC formula was used to calculate these figures: 6 Yield = 2 [(a-b + 1) - 1] --- cd where: a = interest earned during the period b = expenses accrued for the period (net of reimbursements) c = the average daily number of shares outstanding during the period that were entitled to receive dividends d = the maximum offering price per share on the last day of the period TAXABLE-EQUIVALENT YIELD Each fund also may quote a taxable-equivalent yield that shows the before-tax yield that would have to be earned from a taxable investment to equal the yield. Taxable-equivalent yield is computed by dividing the portion of the yield that is tax-exempt by one minus the highest applicable federal or combined federal and state income tax rate and adding the product to the portion of the yield that is not tax-exempt, if any. The taxable-equivalent yields for the 30-day period ended February 28, 1999, were: CLASS A (%) CLASS C (%) - ------------------------------------------------------------------------------- Arizona Fund 6.64 - Florida Fund 6.27 - Insured Fund 6.34 5.60 Massachusetts Fund 6.60 5.86 Michigan Fund 6.43 5.68 Minnesota Fund 6.93 6.17 Ohio Fund 6.82 6.08 As of February 28, 1999, the federal or combined federal and state income tax rate upon which the taxable-equivalent yield quotations were based were as follows: COMBINED RATE (%) - ------------------------------------------------------------------------------- Arizona Fund 42.6 Florida Fund 39.6 Insured Fund 39.6 Massachusetts Fund 43.2 Michigan Fund 42.3 Minnesota Fund 44.7 Ohio Fund 43.7 From time to time, as any changes to the rates become effective, taxable-equivalent yield quotations advertised by the funds will be updated to reflect these changes. The funds expect updates may be necessary as tax rates are changed by federal and state governments. The advantage of tax-free investments, like the funds, will be enhanced by any tax rate increases. Therefore, the details of specific tax increases may be used in sales material for the funds. CURRENT DISTRIBUTION RATE Current yield and taxable-equivalent yield, which are calculated according to a formula prescribed by the SEC, are not indicative of the amounts which were or will be paid to shareholders. Amounts paid to shareholders are reflected in the quoted current distribution rate or taxable-equivalent distribution rate. The current distribution rate is usually computed by annualizing the dividends paid per share by a class during a certain period and dividing that amount by the current maximum offering price. The current distribution rate differs from the current yield computation because it may include distributions to shareholders from sources other than interest, if any, and is calculated over a different period of time. The current distribution rates for the 30-day period ended February 28, 1999, were: CLASS A (%) CLASS C (%) - ------------------------------------------------------------------------------- Arizona Fund 4.45 - Florida Fund 4.47 - Insured Fund 4.78 4.31 Massachusetts Fund 4.66 4.22 Michigan Fund 4.63 4.15 Minnesota Fund 4.73 4.31 Ohio Fund 4.69 4.26 A taxable-equivalent distribution rate shows the taxable distribution rate equivalent to the current distribution rate. The advertised taxable-equivalent distribution rate will reflect the most current federal and state tax rates available to the fund. The taxable-equivalent distribution rates for the 30-day period ended February 28, 1999, were: CLASS A (%) CLASS C (%) - ------------------------------------------------------------------------------- Arizona Fund 7.76 - Florida Fund 7.40 - Insured Fund 7.91 7.14 Massachusetts Fund 8.20 7.43 Michigan Fund 8.02 7.19 Minnesota Fund 8.56 7.80 Ohio Fund 8.33 7.57 VOLATILITY Occasionally statistics may be used to show a fund's volatility or risk. Measures of volatility or risk are generally used to compare a fund's net asset value or performance to a market index. One measure of volatility is beta. Beta is the volatility of a fund relative to the total market, as represented by an index considered representative of the types of securities in which the fund invests. A beta of more than 1.00 indicates volatility greater than the market and a beta of less than 1.00 indicates volatility less than the market. Another measure of volatility or risk is standard deviation. Standard deviation is used to measure variability of net asset value or total return around an average over a specified period of time. The idea is that greater volatility means greater risk undertaken in achieving performance. OTHER PERFORMANCE QUOTATIONS Each fund also may quote the performance of shares without a sales charge. Sales literature and advertising may quote a cumulative total return, average annual total return and other measures of performance with the substitution of net asset value for the public offering price. Each fund may include in its advertising or sales material information relating to investment goals and performance results of funds belonging to the Franklin Templeton Group of Funds. Franklin Resources, Inc. is the parent company of the advisors and underwriter of the Franklin Templeton Group of Funds. COMPARISONS To help you better evaluate how an investment in the fund may satisfy your investment goal, advertisements and other materials about the fund may discuss certain measures of fund performance as reported by various financial publications. Materials also may compare performance (as calculated above) to performance as reported by other investments, indices, and averages. These comparisons may include, but are not limited to, the following examples: o Salomon Brothers Broad Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate and mortgage bonds. o Lehman Brothers Aggregate Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate, mortgage and Yankee bonds. o Lehman Brothers Municipal Bond Index or its component indices - measures yield, price and total return for the municipal bond market. o Bond Buyer 20 Index - an index of municipal bond yields based upon yields of 20 general obligation bonds maturing in 20 years. o Bond Buyer 40 Index - an index composed of the yield to maturity of 40 bonds. The index attempts to track the new-issue market as closely as possible, so it changes bonds twice a month, adding all new bonds that meet certain requirements and deleting an equivalent number according to their secondary market trading activity. As a result, the average par call date, average maturity date, and average coupon rate can and have changed over time. The average maturity generally has been about 29-30 years. o Financial publications: The Wall Street Journal, and Business Week, Financial World, Forbes, Fortune, and Money magazines - provide performance statistics over specified time periods. o Salomon Brothers Composite High Yield Index or its component indices - measures yield, price and total return for the Long-Term High-Yield Index, Intermediate-Term High-Yield Index, and Long-Term Utility High-Yield Index. o Historical data supplied by the research departments of CS First Boston Corporation, the J. P. Morgan companies, Salomon Brothers, Merrill Lynch, Lehman Brothers and Bloomberg L.P. o Morningstar - information published by Morningstar, Inc., including Morningstar proprietary mutual fund ratings. The ratings reflect Morningstar's assessment of the historical risk-adjusted performance of a fund over specified time periods relative to other funds within its category. o Lipper - Mutual Fund Performance Analysis and Lipper - Fixed Income Fund Performance Analysis - measure total return and average current yield for the mutual fund industry and rank individual mutual fund performance over specified time periods, assuming reinvestment of all distributions, exclusive of any applicable sales charges. o Savings and Loan Historical Interest Rates - as published in the U.S. Savings & Loan League Fact Book. o Consumer Price Index (or Cost of Living Index), published by the U.S. Bureau of Labor Statistics - a statistical measure of change, over time, in the price of goods and services in major expenditure groups. o CDA Mutual Fund Report, published by CDA Investment Technologies, Inc. - analyzes price, current yield, risk, total return, and average rate of return (average annual compounded growth rate) over specified time periods for the mutual fund industry. o Standard & Poor's Bond Indices - measure yield and price of corporate, municipal, and government bonds. From time to time, advertisements or information for each fund may include a discussion of certain attributes or benefits to be derived from an investment in the fund. The advertisements or information may include symbols, headlines, or other material that highlights or summarizes the information discussed in more detail in the communication. Advertisements or sales material issued by each fund also may discuss or be based upon information in a recent issue of the Special Report on Tax Freedom Day published by the Tax Foundation, a Washington, D.C. based nonprofit research and public education organization. The report illustrates, among other things, the annual amount of time the average taxpayer works to satisfy his or her tax obligations to the federal, state and local taxing authorities. Advertisements or information also may compare each fund's performance to the return on certificates of deposit (CDs) or other investments. You should be aware, however, that an investment in the fund involves the risk of fluctuation of principal value, a risk generally not present in an investment in a CD issued by a bank. For example, as the general level of interest rates rise, the value of a fund's fixed-income investments, as well as the value of its shares that are based upon the value of such portfolio investments, can be expected to decrease. Conversely, when interest rates decrease, the value of a fund's shares can be expected to increase. CDs are frequently insured by an agency of the U.S. government. An investment in a fund is not insured by any federal, state or private entity. In assessing comparisons of performance, you should keep in mind that the composition of the investments in the reported indices and averages is not identical to any fund's portfolio, the indices and averages are generally unmanaged, and the items included in the calculations of the averages may not be identical to the formula used by a fund to calculate its figures. In addition, there can be no assurance that a fund will continue its performance as compared to these other averages. MISCELLANEOUS INFORMATION - ------------------------------------------------------------------------------- The funds may help you achieve various investment goals such as accumulating money for retirement, saving for a down payment on a home, college costs and other long-term goals. The Franklin College Costs Planner may help you in determining how much money must be invested on a monthly basis in order to have a projected amount available in the future to fund a child's college education. (Projected college cost estimates are based upon current costs published by the College Board.) The Franklin Retirement Planning Guide leads you through the steps to start a retirement savings program. Of course, an investment in the funds cannot guarantee that these goals will be met. The funds are members of the Franklin Templeton Group of Funds, one of the largest mutual fund organizations in the U.S., and may be considered in a program for diversification of assets. Founded in 1947, Franklin is one of the oldest mutual fund organizations and now services more than 4 million shareholder accounts. In 1992, Franklin, a leader in managing fixed-income mutual funds and an innovator in creating domestic equity funds, joined forces with Templeton, a pioneer in international investing. The Mutual Series team, known for its value-driven approach to domestic equity investing, became part of the organization four years later. Together, the Franklin Templeton Group has over $217 billion in assets under management for more than 7 million U.S. based mutual fund shareholder and other accounts. The Franklin Templeton Group of Funds offers 113 U.S. based open-end investment companies to the public. Each fund may identify itself by its NASDAQ symbol or CUSIP number. Franklin is a leader in the tax-free mutual fund industry and manages more than $51 billion in municipal security assets for over three quarters of a million investors. According to Research and Ratings Review, Franklin had one of the largest staffs of municipal securities analysts in the industry, as of June 30, 1998. Under current tax laws, municipal securities remain one of the few investments offering the potential for tax-free income. In 1999, taxes could cost almost $47 on every $100 earned from a fully taxable investment (based on the maximum combined 39.6% federal tax rate and the highest state tax rate of 12% for 1999). Franklin tax-free funds, however, offer tax relief through a professionally managed portfolio of tax-free securities selected based on their yield, quality and maturity. An investment in a Franklin tax-free fund can provide you with the potential to earn income free of federal taxes and, depending on the fund, state and local taxes as well, while supporting state and local public projects. Franklin tax-free funds also may provide tax-free compounding, when dividends are reinvested. An investment in Franklin's tax-free funds can grow more rapidly than similar taxable investments. Municipal securities are generally considered to be creditworthy, second in quality only to securities issued or guaranteed by the U.S. government and its agencies. The market price of municipal securities, however, may fluctuate. This fluctuation will have a direct impact on the net asset value of the fund's shares. Currently, there are more mutual funds than there are stocks listed on the New York Stock Exchange. While many of them have similar investment goals, no two are exactly alike. Shares of the fund are generally sold through securities dealers, whose investment representatives are experienced professionals who can offer advice on the type of investments suitable to your unique goals and needs, as well as the risks associated with such investments. The Information Services & Technology division of Franklin Resources, Inc. (Resources) established a Year 2000 Project Team in 1996. This team has already begun making necessary software changes to help the computer systems that service the funds and their shareholders to be Year 2000 compliant. After completing these modifications, comprehensive tests are conducted in one of Resources' U.S. test labs to verify their effectiveness. Resources continues to seek reasonable assurances from all major hardware, software or data-services suppliers that they will be Year 2000 compliant on a timely basis. Resources is also beginning to develop a contingency plan, including identification of those mission critical systems for which it is practical to develop a contingency plan. However, in an operation as complex and geographically distributed as Resources' business, the alternatives to use of normal systems, especially mission critical systems, or supplies of electricity or long distance voice and data lines are limited. DESCRIPTION OF RATINGS - ------------------------------------------------------------------------------- MUNICIPAL BOND RATINGS MOODY'S INVESTORS SERVICE, INC. (MOODY'S) Aaa: Municipal bonds rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt-edged." Interest payments are protected by a large or exceptionally stable margin, and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa: Municipal bonds rated Aa are judged to be high quality by all standards. Together with the Aaa group, they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large, fluctuation of protective elements may be of greater amplitude, or there may be other elements present that make the long-term risks appear somewhat larger. A: Municipal bonds rated A possess many favorable investment attributes and are considered upper medium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present that suggest a susceptibility to impairment sometime in the future. Baa: Municipal bonds rated Baa are considered medium-grade obligations. They are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. These bonds lack outstanding investment characteristics and, in fact, have speculative characteristics as well. Ba: Municipal bonds rated Ba are judged to have predominantly speculative elements and their future cannot be considered well assured. Often the protection of interest and principal payments may be very moderate and, thereby, not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B: Municipal bonds rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Caa: Municipal bonds rated Caa are of poor standing. These issues may be in default or there may be present elements of danger with respect to principal or interest. Ca: Municipal bonds rated Ca represent obligations that are speculative to a high degree. These issues are often in default or have other marked shortcomings. C: Municipal bonds rated C are the lowest-rated class of bonds and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. Con.(-): Municipal bonds for which the security depends upon the completion of some act or the fulfillment of some condition are rated conditionally. These are bonds secured by (a) earnings of projects under construction, (b) earnings of projects unseasoned in operation experience, (c) rentals that begin when facilities are completed, or (d) payments to which some other limiting condition attaches. Parenthetical rating denotes probable credit stature upon the completion of construction or the elimination of the basis of the condition. STANDARD & POOR'S CORPORATION (S&P) AAA: Municipal bonds rated AAA are the highest-grade obligations. They possess the ultimate degree of protection as to principal and interest. In the market, they move with interest rates and, hence, provide the maximum safety on all counts. AA: Municipal bonds rated AA also qualify as high-grade obligations, and in the majority of instances differ from AAA issues only in a small degree. Here, too, prices move with the long-term money market. A: Municipal bonds rated A are regarded as upper medium-grade. They have considerable investment strength but are not entirely free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They predominantly reflect money rates in their market behavior but also, to some extent, economic conditions. BBB: Municipal bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas they normally exhibit adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds in this category than for bonds in the A category. BB, B, CCC, CC: Municipal bonds rated BB, B, CCC and CC are regarded, on balance, as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal in accordance with the terms of the obligations. BB indicates the lowest degree of speculation and CC the highest degree of speculation. While these bonds will likely have some quality and protective characteristics, they are outweighed by large uncertainties or major risk exposures to adverse conditions. C: This rating is reserved for income bonds on which no interest is being paid. D: Debt rated "D" is in default and payment of interest and/or repayment of principal is in arrears. Plus (+) or minus (-): The ratings from "AA" to "CCC" may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. FITCH INVESTORS SERVICE, INC. (FITCH) AAA: Municipal bonds rated AAA are considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal that is unlikely to be affected by reasonably foreseeable events. AA: Municipal bonds rated AA are considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong although not quite as strong as bonds rated AAA and not significantly vulnerable to foreseeable future developments. A: Municipal bonds rated A are considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB: Municipal bonds rated BBB are considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have an adverse impact on these bonds, and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB: Municipal bonds rated BB are considered speculative. The obligor's ability to pay interest and repay principal may be affected over time by adverse economic changes. Business and financial alternatives can be identified, however, that could assist the obligor in satisfying its debt service requirements. B: Municipal bonds rated B are considered highly speculative. While bonds in this class are currently meeting debt service requirements, the probability of continued timely payment of principal and interest reflects the obligor's limited margin of safety and the need for reasonable business and economic activity throughout the life of the issue. CCC: Municipal bonds rated CCC have certain identifiable characteristics which, if not remedied, may lead to default. The ability to meet obligations requires an advantageous business and economic environment. CC: Municipal bonds rated CC are minimally protected. Default in payment of interest and/or principal seems probable over time. C: Municipal bonds rated C are in imminent default in the payment of interest or principal. DDD, DD and D: Municipal bonds rated DDD, DD and D are in default on interest and/or principal payments. Such bonds are extremely speculative and should be valued on the basis of their ultimate recovery value in liquidation or reorganization of the obligor. DDD represents the highest potential for recovery while D represents the lowest potential for recovery. Plus (+) or minus (-) signs are used with a rating symbol to indicate the relative position of a credit within the rating category. Plus or minus signs are not used with the AAA, DDD, DD or D categories. MUNICIPAL NOTE RATINGS MOODY'S Moody's ratings for state, municipal and other short-term obligations will be designated Moody's Investment Grade (MIG). This distinction is in recognition of the differences between short-term credit risk and long-term risk. Factors affecting the liquidity of the borrower are uppermost in importance in short-term borrowing; factors of the first importance in long-term borrowing risk are of lesser importance in the short run. Symbols used will be as follows: MIG 1: Notes are of the best quality enjoying strong protection from established cash flows of funds for their servicing or from established and broad-based access to the market for refinancing, or both. MIG 2: Notes are of high quality, with margins of protection ample, although not so large as in the preceding group. MIG 3: Notes are of favorable quality, with all security elements accounted for, but lacking the undeniable strength of the preceding grades. Market access for refinancing, in particular, is likely to be less well established. MIG 4: Notes are of adequate quality, carrying specific risk but having protection and not distinctly or predominantly speculative. S&P Until June 29, 1984, S&P used the same rating symbols for notes and bonds. After June 29, 1984, for new municipal note issues due in three years or less, the ratings below will usually be assigned. Notes maturing beyond three years will most likely receive a bond rating of the type recited above. SP-1: Issues carrying this designation have a very strong or strong capacity to pay principal and interest. Issues determined to possess overwhelming safety characteristics will be given a "plus" (+) designation. SP-2: Issues carrying this designation have a satisfactory capacity to pay principal and interest. SHORT-TERM DEBT & COMMERCIAL PAPER RATINGS MOODY'S Moody's short-term debt ratings are opinions of the ability of issuers to repay punctually senior debt obligations. These obligations have an original maturity not exceeding one year, unless explicitly noted. Moody's commercial paper ratings, which are also applicable to municipal paper investments, are opinions of the ability of issuers to repay punctually their promissory obligations not having an original maturity in excess of nine months. Moody's employs the following designations for both short-term debt and commercial paper, all judged to be investment grade, to indicate the relative repayment capacity of rated issuers: P-1 (Prime-1): Superior capacity for repayment. P-2 (Prime-2): Strong capacity for repayment. S&P S&P's ratings are a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Ratings are graded into four categories, ranging from "A" for the highest quality obligations to "D" for the lowest. Issues within the "A" category are delineated with the numbers 1, 2 and 3 to indicate the relative degree of safety, as follows: A-1: This designation indicates the degree of safety regarding timely payment is very strong. A "plus" (+) designation indicates an even stronger likelihood of timely payment. A-2: Capacity for timely payment on issues with this designation is strong. The relative degree of safety, however, is not as overwhelming as for issues designated A-1. A-3: Issues carrying this designation have a satisfactory capacity for timely payment. They are, however, somewhat more vulnerable to the adverse effects of changes in circumstances than obligations carrying the higher designations. FITCH Fitch's short-term ratings apply to debt obligations that are payable on demand or have original maturities of generally up to three years, including commercial paper, certificates of deposit, medium-term notes, and municipal and investment notes. The short-term rating places greater emphasis than a long-term rating on the existence of liquidity necessary to meet the issuer's obligations in a timely manner. F-1+: Exceptionally strong credit quality. Regarded as having the strongest degree of assurance for timely payment. F-1: Very strong credit quality. Reflect an assurance of timely payment only slightly less in degree than issues rated F-1+. F-2: Good credit quality. A satisfactory degree of assurance for timely payment, but the margin of safety is not as great as for issues assigned F-1+ and F-1 ratings. F-3: Fair credit quality. Have characteristics suggesting that the degree of assurance for timely payment is adequate; however, near-term adverse changes could cause these securities to be rated below investment grade. F-5: Weak credit quality. Have characteristics suggesting a minimal degree of assurance for timely payment and are vulnerable to near-term adverse changes in financial and economic conditions. D: Default. Actual or imminent payment default. LOC: The symbol LOC indicates that the rating is based on a letter of credit issued by a commercial bank. STATE TAX TREATMENT - ------------------------------------------------------------------------------- The following information on the state income tax treatment of dividends from the funds is based upon correspondence and sources believed to be reliable. Except where otherwise noted, the information pertains to individual state income taxation only. You may be subject to local taxes on dividends or the value of your shares. Corporations, trusts, estates and other entities may be subject to other taxes and should consult with their tax advisors or their state department of revenue. For some investors, a portion of the dividend income may be subject to the federal and/or state alternative minimum tax. ARIZONA Sections 43-1021(4) and 43-1121(3) of the Arizona Income Tax Code state that interest on obligations of the state of Arizona or its political subdivisions is exempt from personal and corporate income tax. Sections 43-1022(6) and 43-1122(6) provide similar tax-exempt treatment for interest on obligations of the U.S. or its territories (including Puerto Rico, Guam and the Virgin Islands). Pursuant to State Income Tax Ruling Number 84-10-5, Arizona does not tax dividend income from regulated investment companies, such as the Arizona Fund, to the extent that such income is derived from such exempt obligations. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.), or obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gain earned by the fund are included in each shareholder's Arizona taxable income as dividend income and long-term capital gain, respectively, and are taxed at ordinary income tax rates. FLORIDA Florida does not have a personal income tax but does have an intangible personal property tax for residents. According to Florida Statute Section 199.185 and Technical Assistance Advisement 90(C)2-003, issued by the Florida Department of Revenue on August 8, 1990 (as later revised), shares in regulated investment companies organized as business trusts, such as the Florida Fund, will not be subject to Florida's intangible property tax to the extent that the fund is invested in exempt obligations of the U.S. government, its agencies, instrumentalities or territories (including Puerto Rico, Guam and the Virgin Islands) at the close of business on the last business day of the previous calendar year. If the fund invests all of the remaining portion of its net asset value in exempt obligations of the state of Florida or its municipalities or political subdivisions on such date, then that remaining portion of the net asset value of the fund (and corresponding value of fund shares) also will be exempt from Florida's intangibles tax. According to Florida Technical Assistance Advisement 94(c)2-025, if the fund invests, such as for temporary or defensive purposes, any of the remaining portion of its portfolio in any asset that is taxable under Florida's intangible tax law, including investments in indirect federal obligations (GNMAs, FNMAs, etc.) or obligations of any other states, then only the portion of net asset value, if any, that is made up of direct obligations of the U.S. government, or territories and possessions of the U.S. government, may be excluded from tax. The remaining net asset value (and corresponding value of fund shares) of the fund is subject to tax. MASSACHUSETTS Chapter 62, Section 2, of the Massachusetts General Laws states that dividends received from a regulated investment company, such as the Massachusetts Fund, are exempt from state personal income tax to the extent that such dividends are attributable to interest on obligations of the U.S. government or its territories (including Puerto Rico, Guam and the Virgin Islands). Dividends received from the fund, which are either exempt-interest dividends or capital gain dividends, to the extent that the interest or gains are attributable to obligations of the Commonwealth of Massachusetts, or any political subdivision, agency or instrumentality within the commonwealth, also are exempt from state personal income tax. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or other obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Capital gain dividends attributable to obligations other than of the Commonwealth of Massachusetts, or any political subdivision, agency or instrumentality thereof will be taxable as follows: Net short-term capital gain distributions will be taxable as dividend income while net long-term capital gain distributions will be taxable at reduced rates ranging from five percent to two percent based upon the applicable holding period of the asset as determined under Massachusetts law. By the 2001 tax year, these reduced rates will range from five percent to zero percent. In determining the Massachusetts excise tax on corporations subject to state taxation, distributions from the fund generally will be included in a corporate shareholder's net income, and in the case of corporations that are defined as "intangible property corporations," shares of the fund will be included in the computation of net worth. MICHIGAN Section 206.30(1) of the Michigan Compiled Laws generally provides that taxable income, for purposes of the Michigan individual income tax, is determined by reference to federal adjusted gross income, with certain modifications. Interest and dividends derived from obligations or securities of states other than Michigan (less related expenses) must be added back in determining Michigan taxable income. Interest and dividends derived from obligations or securities of Michigan (and its political subdivisions) are exempt and are not, therefore, added back in determining Michigan taxable income. Further, income derived from obligations of the U.S. government that the state is prohibited by law from subjecting to a net income tax is subtracted in determining Michigan taxable income. This includes direct obligations of the U.S. government, its agencies, instrumentalities, or possessions (including Puerto Rico, Guam and the Virgin Islands). Revenue Administrative Bulletin 1986-3, states that a regulated investment company, such as the Michigan Fund, which invests in tax-free municipal obligations of the state of Michigan and its political and governmental subdivisions, is permitted to pass-through the exemption of such interest to its shareholders to the extent that such interest qualifies as an exempt-interest dividend of a regulated investment company. The exempt nature of interest from obligations of the U.S. and its territories and possessions also may be passed through to shareholders. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or other obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund generally will be included in each shareholder's Michigan taxable income as dividend income and long-term capital gain, respectively, and taxed at ordinary income tax rates. MINNESOTA Section 290.01 of the Code of Minnesota states that individual shareholders generally will not be subject to state income taxation on the exempt-interest dividends distributed by a regulated investment company, such as the Minnesota Fund, provided that at least 95% of the exempt-interest dividends are derived from obligations of the state of Minnesota, or its political or governmental subdivisions. However, such dividends are taken into account in computing the state's alternative minimum tax to the extent they are derived from Minnesota private activity bonds. Minnesota Rule 8002.0300 generally states that dividends paid by the fund, to the extent attributable to interest derived from obligations of the U.S. government, its authorities, commissions, instrumentalities or territories (including Puerto Rico, Guam and the Virgin Islands), also will be exempt from Minnesota's personal income tax. As a matter of policy, the fund will continue to seek to earn at least 95% of its income from interest on Minnesota obligations and less than 5% from direct U.S. government, Puerto Rico or other obligations to try to ensure that the fund continues to qualify to pay exempt-interest dividends on income from Minnesota obligations. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or other obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund are included in each shareholder's Minnesota taxable income as dividend income and long-term capital gain respectively, and are taxed at ordinary income tax rates. OHIO Section 5747.01(A) of the Ohio Revised Code states generally that interest on obligations of the state of Ohio and its subdivisions and authorities and of the U.S. and its territories and possessions (to the extent included in federal adjusted gross income but exempt from state income taxes under U.S. laws) is exempt from Ohio state personal income tax. Distributions of income attributable to obligations of the U.S., its territories and possessions by regulated investment companies, such as the Ohio Fund, also will be exempt from the Ohio personal income tax and the Ohio corporation franchise tax computed on the net income basis. In addition, distributions made by the Ohio Fund that are attributable to interest payments on obligations issued by or on behalf of the state of Ohio, its political subdivisions or agencies or instrumentalities or its political subdivisions will be exempt from Ohio personal income tax provided that at all times at least 50 percent of the value of the total assets of the Ohio Fund consists of Ohio obligations, or similar obligations of other states or their subdivisions. Shares of the Ohio Fund will, however, be included in a shareholder's tax base for purposes of computing the Ohio corporation franchise tax on the net worth basis. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or other obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable on a pro rata basis. Shareholders who are subject to the Ohio personal income tax or the Ohio corporation franchise tax computed on the net income basis will not be subject to such taxes on distributions of "capital gain dividends" to the extent that such distributions are attributable to profit made on the sale, exchange or other disposition by the Ohio Fund of exempt obligations of the state of Ohio and its subdivisions and authorities. FRANKLIN TAX-FREE TRUST FRANKLIN ALABAMA TAX-FREE INCOME FUND FRANKLIN FLORIDA TAX-FREE INCOME FUND FRANKLIN GEORGIA TAX-FREE INCOME FUND FRANKLIN KENTUCKY TAX-FREE INCOME FUND FRANKLIN LOUISIANA TAX-FREE INCOME FUND FRANKLIN MARYLAND TAX-FREE INCOME FUND FRANKLIN MISSOURI TAX-FREE INCOME FUND FRANKLIN NORTH CAROLINA TAX-FREE INCOME FUND FRANKLIN TEXAS TAX-FREE INCOME FUND FRANKLIN VIRGINIA TAX-FREE INCOME FUND STATEMENT OF ADDITIONAL INFORMATION [INSERT FRANKLIN TEMPLETON BEN HEAD] P.O. BOX 997151, SACRAMENTO, CA 95899-9983 1-800/DIAL BEN(R) JULY 1, 1999 This Statement of Additional Information (SAI) is not a prospectus. It contains information in addition to the information in the funds' prospectus. The funds' prospectus, dated July 1, 1999, which we may amend from time to time, contains the basic information you should know before investing in the funds. You should read this SAI together with the funds' prospectus. The audited financial statements and auditor's report in the trust's Annual Report to Shareholders, for the fiscal year ended February 28, 1999, are incorporated by reference (are legally a part of this SAI). For a free copy of the current prospectus or annual report, contact your investment representative or call 1-800/DIAL BEN (1-800/342-5236). CONTENTS Goals and Strategies ........................... 2 Risks .......................................... 6 Officers and Trustees .......................... 10 Management and Other Services .................. 12 Portfolio Transactions ......................... 14 Distributions and Taxes ........................ 14 Organization, Voting Rights and Principal Holders ......................... 16 Buying and Selling Shares ...................... 17 Pricing Shares ................................. 22 The Underwriter ................................ 22 Performance .................................... 25 Miscellaneous Information ...................... 28 Description of Ratings ......................... 29 State Tax Treatment ............................ 31 - ------------------------------------------------------------------------------ MUTUAL FUNDS, ANNUITIES, AND OTHER INVESTMENT PRODUCTS: o ARE NOT FEDERALLY INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY OF THE U.S. GOVERNMENT; o ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED BY, ANY BANK; o ARE SUBJECT TO INVESTMENT RISKS, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. - ------------------------------------------------------------------------------- GOALS AND STRATEGIES - ------------------------------------------------------------------------------- Each fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. Each fund also tries to provide a maximum level of income exempt from personal income taxes, if any, for resident shareholders of the fund's state. These goals are fundamental, which means they may not be changed without shareholder approval. Of course, there is no assurance that any fund will meet its goal. As fundamental policies, each fund normally invests at least 80% of its net assets in securities that pay interest free from federal income taxes, including the federal alternative minimum tax, and at least 80% of its net assets in securities that pay interest free from the personal income taxes, if any, of its state. As a nonfundamental policy, each fund also normally invests at least 65% of its total assets in municipal securities of its state. Municipal securities issued by a fund's state or that state's counties, municipalities, authorities, agencies, or other subdivisions, as well as municipal securities issued by U.S. territories such as Guam, Puerto Rico, or the Mariana Islands, generally pay interest free from federal income tax and from state personal income taxes, if any, for residents of the fund's state. Each fund tries to invest all of its assets in tax-free municipal securities. The issuer's bond counsel generally gives the issuer an opinion on the tax-exempt status of a municipal security when the security is issued. Some states may require a fund to invest a certain amount of its assets in securities of that state, or in securities that are otherwise tax-free under the laws of that state, in order for any portion of the fund's distributions to be free from the state's personal income taxes. If a fund's state requires this, the fund will try to invest its assets as required so that its distributions will be free from personal income taxes for resident shareholder's of the fund's state. Below is a description of various types of municipal and other securities that each fund may buy. Other types of municipal securities may become available that are similar to those described below and in which each fund also may invest, if consistent with its investment goal and policies. TAX ANTICIPATION NOTES are issued to finance short-term working capital needs of municipalities in anticipation of various seasonal tax revenues, which will be used to pay the notes. They are usually general obligations of the issuer, secured by the taxing power for the payment of principal and interest. REVENUE ANTICIPATION NOTES are similar to tax anticipation notes except they are issued in expectation of the receipt of other kinds of revenue, such as federal revenues available under the Federal Revenue Sharing Program. BOND ANTICIPATION NOTES are normally issued to provide interim financing until long-term financing can be arranged. Proceeds from long-term bond issues then provide the money for the repayment of the notes. TAX-EXEMPT COMMERCIAL PAPER typically represents a short-term obligation (270 days or less) issued by a municipality to meet working capital needs. MUNICIPAL BONDS meet longer-term capital needs and generally have maturities from one to 30 years when issued. They have two principal classifications: general obligation bonds and revenue bonds. GENERAL OBLIGATION BONds. Issuers of general obligation bonds include states, counties, cities, towns and regional districts. The proceeds of these obligations are used to fund a wide range of public projects, including construction or improvement of schools, highways and roads. The basic security behind general obligation bonds is the issuer's pledge of its full faith, credit and taxing power for the payment of principal and interest. The taxes that can be levied for the payment of debt service may be limited or unlimited as to the rate or amount of special assessments. REVENUE BONDS. The full faith, credit and taxing power of the issuer do not secure revenue bonds. Instead, the principal security for a revenue bond is generally the net revenue derived from a particular facility, group of facilities, or, in some cases, the proceeds of a special excise tax or other specific revenue source. Revenue bonds are issued to finance a wide variety of capital projects, including: electric, gas, water and sewer systems; highways, bridges and tunnels; port and airport facilities; colleges and universities; and hospitals. The principal security behind these bonds may vary. For example, housing finance authorities have a wide range of security, including partially or fully insured mortgages, rent subsidized and/or collateralized mortgages, and/or the net revenues from housing or other public projects. Many bonds provide additional security in the form of a debt service reserve fund that may be used to make principal and interest payments. Some authorities have further security in the form of state assurances (although without obligation) to make up deficiencies in the debt service reserve fund. TAX-EXEMPT INDUSTRIAL DEVELOPMENT REVENUE BONDS are issued by or on behalf of public authorities to finance various privately operated facilities for business, manufacturing, housing, sports and pollution control, as well as public facilities such as airports, mass transit systems, ports and parking. The payment of principal and interest is solely dependent on the ability of the facility's user to meet its financial obligations and the pledge, if any, of the facility or other property as security for payment. VARIABLE OR FLOATING RATE SECURITIES Each fund may invest in variable or floating rate securities, including variable rate demand notes, which have interest rates that change either at specific intervals (variable rate), from daily up to monthly, or whenever a benchmark rate changes (floating rate). The interest rate adjustments are designed to help stabilize the security's price. While this feature helps protect against a decline in the security's market price when interest rates go up, it lowers the fund's income when interest rates fall. Variable or floating rate securities may include a demand feature, which may be unconditional. The demand feature allows the holder to demand prepayment of the principal amount before maturity, generally on one to 30 days' notice. The holder receives the principal amount plus any accrued interest either from the issuer or by drawing on a bank letter of credit, a guarantee or insurance issued with respect to the security. Each fund generally uses variable or floating rate securities as short-term investments while waiting for long-term investment opportunities. MUNICIPAL LEASE OBLIGATIONS Each fund may invest in municipal lease obligations, including certificates of participation. Municipal lease obligations generally finance the purchase of public property. The property is leased to the state or a local government, and the lease payments are used to pay the interest on the obligations. Municipal lease obligations differ from other municipal securities because the lessee's governing body must appropriate (set aside) the money to make the lease payments each year. If the money is not appropriated, the issuer or the lessee can end the lease without penalty. If the lease is cancelled, investors who own the municipal lease obligations may not be paid. The board of trustees reviews each fund's municipal lease obligations to try to assure that they are liquid investments based on various factors reviewed by the fund's manager and monitored by the board. These factors may include (a) the credit quality of the obligations and the extent to which they are rated or, if unrated, comply with existing criteria and procedures followed to ensure that they are comparable in quality to the ratings required for the fund to invest, including an assessment of the likelihood of the lease being canceled, taking into account how essential the leased property is and the term of the lease compared to the useful life of the leased property; (b) the size of the municipal securities market, both in general and with respect to municipal lease obligations; and (c) the extent to which the type of municipal lease obligations held by the fund trade on the same basis and with the same degree of dealer participation as other municipal securities of comparable credit rating or quality. Since annual appropriations are required to make lease payments, municipal lease obligations generally are not subject to constitutional limitations on the issuance of debt and may allow an issuer to increase government liabilities beyond constitutional debt limits. When faced with increasingly tight budgets, local governments have more discretion to curtail lease payments under a municipal lease obligation than they do to curtail payments on other municipal securities. If not enough money is appropriated to make the lease payments, the leased property may be repossessed as security for holders of the municipal lease obligations. If this happens, there is no assurance that the property's private sector or re-leasing value will be enough to make all outstanding payments on the municipal lease obligations or that the payments will continue to be tax-free. While cancellation risk is inherent to municipal lease obligations, each fund believes that this risk may be reduced, although not eliminated, by its policies on the quality of securities in which it may invest. CALLABLE BONDS Each fund may invest in callable bonds, which allow the issuer to repay some or all of the bonds ahead of schedule. If a bond is called, the fund will receive the principal amount, the accrued interest, and may receive a small additional payment as a call premium. The manager may sell a callable bond before its call date, if it believes the bond is at its maximum premium potential. When pricing callable bonds, the call feature is factored into the price of the bonds and may impact the fund's net asset value. An issuer is more likely to call its bonds when interest rates are falling, because the issuer can issue new bonds with lower interest payments. If a bond is called, the fund may have to replace it with a lower-yielding security. A call of some or all of these securities may lower a fund's income and its distributions to shareholders. If the fund originally paid a premium for the bond because it had appreciated in value from its original issue price, the fund also may not be able to recover the full amount it paid for the bond. One way for the fund to protect itself from call risk is to buy bonds with call protection. Call protection is an assurance that the bond will not be called for a specific time period, typically five to 10 years from when the bond is issued. ESCROW-SECURED OR DEFEASED BONDS are created when an issuer refunds, before maturity, an outstanding bond issue that is not immediately callable (or pre-refunds), and sets aside funds for redemption of the bonds at a future date. The issuer uses the proceeds from a new bond issue to buy high grade, interest bearing debt securities, generally direct obligations of the U.S. government. These securities are then deposited in an irrevocable escrow account held by a trustee bank to secure all future payments of principal and interest on the pre-refunded bond. Escrow-secured bonds often receive a triple A or equivalent rating. STRIPPED MUNICIPAL SECURITIES Municipal securities may be sold in "stripped" form. Stripped municipal securities represent separate ownership of principal and interest payments on municipal securities. ZERO-COUPON SECURITIES Each fund may invest in zero-coupon and delayed interest securities. Zero-coupon securities make no periodic interest payments, but are sold at a deep discount from their face value. The buyer recognizes a rate of return determined by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. The discount varies depending on the time remaining until maturity, as well as market interest rates, liquidity of the security, and the issuer's perceived credit quality. The discount, in the absence of financial difficulties of the issuer, typically decreases as the final maturity date approaches. If the issuer defaults, the fund may not receive any return on its investment. Because zero-coupon securities bear no interest and compound semiannually at the rate fixed at the time of issuance, their value is generally more volatile than the value of other fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zero-coupon securities fall more dramatically than bonds paying interest on a current basis when interest rates rise. When interest rates fall, zero-coupon securities rise more rapidly in value, because the bonds reflect a fixed rate of return. An investment in zero-coupon and delayed interest securities may cause a fund to recognize income and make distributions to shareholders before it receives any cash payments on its investment. To generate cash to satisfy distribution requirements, a fund may have to sell portfolio securities that it otherwise would have continued to hold or to use cash flows from other sources such as the sale of fund shares. CONVERTIBLE AND STEP COUPON BONDS Each fund may invest a portion of its assets in convertible and step coupon bonds. Convertible bonds are zero-coupon securities until a predetermined date, at which time they convert to a specified coupon security. The coupon on step coupon bonds changes periodically during the life of the security based on predetermined dates chosen when the security is issued. U.S. GOVERNMENT OBLIGATIONS are issued by the U.S. Treasury or by agencies and instrumentalities of the U.S. government and are backed by the full faith and credit of the U.S. government. They include Treasury bills, notes and bonds. COMMERCIAL PAPER is a promissory note issued by a corporation to finance its short-term credit needs. Each fund may invest in taxable commercial paper only for temporary defensive purposes. WHEN-ISSUED TRANSACTIONS Municipal securities are frequently offered on a "when-issued" basis. When so offered, the price, which is generally expressed in yield terms, is fixed at the time the commitment to buy is made, but delivery and payment take place at a later date. During the time between purchase and settlement, no payment is made by the fund to the issuer and no interest accrues to the fund. If the other party to the transaction fails to deliver or pay for the security, the fund could miss a favorable price or yield opportunity, or could experience a loss. When the fund makes the commitment to buy a municipal security on a when-issued basis, it records the transaction and reflects the value of the security in the determination of its net asset value. The funds believe their net asset value or income will not be negatively affected by their purchase of municipal securities on a when-issued basis. The funds will not engage in when-issued transactions for investment leverage purposes. Although a fund will generally buy municipal securities on a when-issued basis with the intention of acquiring the securities, it may sell the securities before the settlement date if it is considered advisable. When a fund is the buyer, it will maintain cash or liquid securities, with an aggregate value equal to the amount of its purchase commitments, in a segregated account with its custodian bank until payment is made. If assets of a fund are held in cash pending the settlement of a purchase of securities, the fund will not earn income on those assets. ILLIQUID INVESTMENTS Each fund may invest up to 10% of its net assets in illiquid securities. Illiquid securities are generally securities that cannot be sold within seven days in the normal course of business at approximately the amount at which the fund has valued them. DIVERSIFICATION All of the funds, except the Maryland Fund, are diversified funds. The Maryland Fund is non-diversified. As a fundamental policy, none of the diversified funds will buy a security if, with respect to 75% of its net assets, more than 5% would be in the securities of any single issuer (with the exception of obligations of the U.S. government). For this purpose, each political subdivision, agency, or instrumentality, each multi-state agency of which a state is a member, and each public authority that issues private activity bonds on behalf of a private entity, is considered a separate issuer. Escrow-secured or defeased bonds are not generally considered an obligation of the original municipality when determining diversification. Each fund, including the Maryland Fund, intends to meet certain diversification requirements for tax purposes. Generally, to meet federal tax requirements at the close of each quarter, a fund may not invest more than 25% of its total assets in any one issuer and, with respect to 50% of total assets, may not invest more than 5% of its total assets in any one issuer. These limitations do not apply to U.S. government securities and may be revised if applicable federal income tax requirements are revised. TEMPORARY INVESTMENTS When the manager believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist, including the unavailability of securities that meet a fund's investment criteria, it may invest each fund's portfolio in a temporary defensive manner. Under these circumstances, each fund may invest all of its assets in securities that pay taxable interest, including (i) high quality commercial paper; (ii) securities issued by or guaranteed by the full faith and credit of the U.S. government; or (iii) municipal securities issued by a state or local government other than the fund's state. Each fund also may invest all of its assets in municipal securities issued by a U.S. territory such as Guam, Puerto Rico or the Mariana Islands. SECURITIES TRANSACTIONS The frequency of portfolio transactions, usually referred to as the portfolio turnover rate, varies for each fund from year to year, depending on market conditions. While short-term trading increases portfolio turnover and may increase costs, the execution costs for municipal securities are substantially less than for equivalent dollar values of equity securities. CREDIT QUALITY All things being equal, the lower a security's credit quality, the higher the risk and the higher the yield the security generally must pay as compensation to investors for the higher risk. A security's credit quality depends on the issuer's ability to pay interest on the security and, ultimately, to repay the principal. Independent rating agencies, such as Fitch Investors Service Inc. (Fitch), Moody's Investors Service, Inc. (Moody's), and Standard & Poor's Corporation (S&P), often rate municipal securities based on their opinion of the issuer's credit quality. Most rating agencies use a descending alphabet scale to rate long-term securities, and a descending numerical scale to rate short-term securities. Securities in the top four ratings are "investment grade," although securities in the fourth highest rating may have some speculative features. These ratings are described at the end of this SAI under "Description of Ratings." An insurance company, bank or other foreign or domestic entity may provide credit support for a municipal security and enhance its credit quality. For example, some municipal securities are insured, which means they are covered by an insurance policy that guarantees the timely payment of principal and interest. Other municipal securities may be backed by letters of credit, guarantees, or escrow or trust accounts that contain securities backed by the full faith and credit of the U.S. government to secure the payment of principal and interest. As discussed in the prospectus, each fund has limitations on the credit quality of the securities it may buy. These limitations are generally applied when a fund makes an investment so that a fund is not required to sell a security because of a later change in circumstances. INVESTMENT RESTRICTIONS Each fund has adopted the following restrictions as fundamental policies. This means they may only be changed if the change is approved by (i) more than 50% of the fund's outstanding shares or (ii) 67% or more of the fund's shares present at a shareholder meeting if more than 50% of the fund's outstanding shares are represented at the meeting in person or by proxy, whichever is less. Each fund may not: 1. Borrow money or mortgage or pledge any of its assets, except that borrowings (and a pledge of assets therefore) for temporary or emergency purposes may be made from banks in any amount up to 5% of the total asset value. 2. Buy any securities on "margin" or sell any securities "short," except that it may use such short-term credits as are necessary for the clearance of transactions. 3. Make loans, except through the purchase of readily marketable debt securities which are either publicly distributed or customarily purchased by institutional investors. Although such loans are not presently intended, this prohibition will not preclude the fund from loaning portfolio securities to broker-dealers or other institutional investors if at least 102% cash collateral is pledged and maintained by the borrower; provided such portfolio security loans may not be made if, as a result, the aggregate of such loans exceeds 10% of the value of the fund's total assets at the time of the most recent loan. 4. Act as underwriter of securities issued by other persons, except insofar as the fund may be technically deemed an underwriter under the federal securities laws in connection with the disposition of portfolio securities. 5. Purchase the securities of any issuer which would result in owning more than 10% of the voting securities of such issuer, except with respect to the Maryland Fund, which will not purchase a security, if as a result: i) more than 25% of its total assets would be invested in the securities of a single issuer or ii) with respect to 50% of its total assets, more than 5% of its assets would be invested in the securities of a single issuer. 6. Purchase securities from or sell to the trust's officers and trustees, or any firm of which any officer or trustee is a member, as principal, or retain securities of any issuer if, to the knowledge of the trust, one or more of the trust's officers, trustees, or investment manager own beneficially more than one-half of 1% of the securities of such issuer and all such officers and trustees together own beneficially more than 5% of such securities. 7. Acquire, lease or hold real estate, except such as may be necessary or advisable for the maintenance of its offices and provided that this limitation shall not prohibit the purchase of municipal and other debt securities secured by real estate or interests therein. 8. Invest in commodities and commodity contracts, puts, calls, straddles, spreads or any combination thereof, or interests in oil, gas, or other mineral exploration or development programs, except that it may purchase, hold and dispose of "obligations with puts attached" in accordance with its investment policies. 9. Invest in companies for the purpose of exercising control or management. 10. Purchase securities of other investment companies, except in connection with a merger, consolidation or reorganization, except to the extent the fund invests its uninvested daily cash balances in shares of the Franklin Tax-Exempt Money Fund and other tax-exempt money funds in the Franklin Templeton Group of Funds provided i) its purchases and redemptions of such money market fund shares may not be subject to any purchase or redemption fees, ii) its investments may not be subject to duplication of management fees, nor to any charge related to the expense of distributing the fund's shares (as determined under Rule 12b-1, as amended under the federal securities laws) and iii) aggregate investments by the fund in any such money market fund do not exceed (A) the greater of (i) 5% of the fund's total net assets or (ii) $2.5 million, or (B) more than 3% of the outstanding shares of any such money market fund. 11. Invest more than 25% of its assets in securities of any industry; although for purposes of this limitation, tax-exempt securities and U.S. government obligations are not considered to be part of any industry. If a bankruptcy or other extraordinary event occurs concerning a particular security the fund owns, the fund may receive stock, real estate, or other investments that the fund would not, or could not, buy. If this happens, the fund intends to sell such investments as soon as practicable while maximizing the return to shareholders. Generally, the policies and restrictions discussed in this SAI and in the prospectus apply when the fund makes an investment. In most cases, the fund is not required to sell a security because circumstances change and the security no longer meets one or more of the fund's policies or restrictions. If a percentage restriction or limitation is met at the time of investment, a later increase or decrease in the percentage due to a change in the value or liquidity of portfolio securities will not be considered a violation of the restriction or limitation. RISKS - ------------------------------------------------------------------------------ STATE Since each state fund mainly invests in the municipal securities of its state, its performance is closely tied to the ability of issuers of municipal securities in its state to continue to make principal and interest payments on their securities. The issuers' ability to do this is in turn dependent on economic, political and other conditions within the state. Below is a discussion of certain conditions that may affect municipal issuers in the funds' various states. It is not a complete analysis of every material fact that may affect the ability of issuers of municipal securities to meet their debt obligations or the economic or political conditions within any state and is subject to change. The information below is based on data available to the funds from historically reliable sources, but the funds have not independently verified it. The ability of issuers of municipal securities to continue to make principal and interest payments is dependent in large part on their ability to raise revenues, primarily through taxes, and to control spending. Many factors can affect a state's revenues including the rate of population growth, unemployment rates, personal income growth, federal aid, and the ability to attract and keep successful businesses. A number of factors can also affect a state's spending including current debt levels, and the existence of accumulated budget deficits. The following provides some information on these and other factors. ALABAMA. Alabama's economic base has continued to expand and diversify. Although manufacturing has remained an important part of the economy, the trade and service sectors have supplied almost 75% of the state's recent job growth. The state's economic diversification has been fueled by growth in high tech industries, health care and business services, and has centered around the state's major metropolitan areas. Aggressive economic development and business recruitment policies have helped to increase growth throughout the state. In recent years, these policies have brought in significant capital investments, which may help Alabama offset losses in its textile, apparel and food processing sectors. Nonetheless, Alabama's economic growth and personal income levels have continued to lag national and regional averages. Historically, Alabama has been able to maintain a relatively low overall debt burden, as well as balanced financial operations. Under the state's constitution, expenditure reductions are required to prevent deficit spending should the state experience revenue shortfalls. Since fiscal 1993, across the board cuts have not been needed due mainly to Alabama's recent economic growth and strict cost containment measures. Alabama has been under a court order to remedy constitutional violations of funding equity and adequacy in its school systems. The Alabama Special Educational Trust Fund has been the state's largest operating fund and has been funded primarily by income, sales and use taxes. Although the state's substantial funding requirements for its school systems may put some pressure on its budget and financial operations, overall both Moody's and S&P recently considered the state's financial outlook to be stable. FLORIDA. Florida's population has grown rapidly in recent years, with the fastest growth among 5-17 year-olds and seniors 65 and over. The rapid growth among these age groups has required increased expenditures for services such as schools and health care and has placed sustained pressure on the state's budget for the funding of these services. As a result, Florida is more vulnerable to increases in the cost of education, Medicaid and other health care services than many other states. While the population of the young and old has grown rapidly, the working age population has grown at a much slower rate and is expected to decline in the coming years. Because of its substantial retirement age population, investment income and transfer payments, such as social security and pension benefits, made up more than 44% of Florida's income distribution in 1997. Wages and salaries were more than 49%. This income mix historically has led to relatively stable personal income levels across different economic cycles, although it also has created some vulnerability to changes in the consumer price index at the federal level. Florida's tax base has been relatively narrow, with no personal income tax and 60% of its revenues derived from the state's sales and use tax. This reliance on a cyclical revenue source has created some vulnerability to recession and slower growth in the tax base. Recent trends also have shown an increase in internet and mail order sales, which the state has not been able to tax. If this trend continues, states that rely on sales taxes, like Florida, could be adversely affected. To help provide some protection against the historically volatile nature of the sales tax, Florida enacted a constitutional amendment creating a budget stabilization fund. As of March 1999, Florida projected a balance in the fund of $787 million by the end of fiscal 1999. Over the past five years, Florida's debt burden has grown dramatically with the increased need for schools and health care, as well as environmental protection programs designed to help protect the state's important tourism industry. The state's rapidly growing population should continue to place demands on the state's budget and debt burden to finance infrastructure and other improvements. While tourism has remained Florida's most important industry, Florida's economy has continued to diversify from a narrow base of agriculture and seasonal tourism into a service and trade economy. Job growth has been steady, slightly higher than the national average, and unemployment has been around the national rate. Because of its location, much of the state's export sector has relied on exports to Latin America. Although exports have comprised a relatively small part of the gross state product, the sector's dependence on Latin America poses a risk in the event of economic instability in that region. GEORGIA. Georgia has been among the fastest growing states in the U.S. in population, which has helped fuel employment growth and provide low-cost labor for economic growth. Its diversified economy has performed well in recent years, with growth in the services and trade sectors driving the state's overall employment growth. Other factors that have contributed to Georgia's recent economic growth have been the state's low cost of doing business, extensive transportation infrastructure, low unemployment rates, availability of land and water, and its central location. Atlanta, which has been at the heart of the state's economic growth, has been a trade, service and transportation center for much of the southeast region. Financially, the state's strong economic and revenue growth have so far allowed the state to meet the needs of its growing population, while maintaining a sound financial position. The state has generated operating surpluses in each of the last four fiscal years from 1995 to 1998, and also has fully funded its reserves. While changes to the state's tax laws are expected to reduce tax revenues by more than $200 million in fiscal 1999, as of November 1998 it was not anticipated that these changes would have an adverse effect on the state's overall financial position. KENTUCKY. Kentucky's economy has performed at or above national levels in both employment and personal income growth over the past several years. Its economy has been moving towards a more modern manufacturing and service-oriented base, with less emphasis on its traditionally low-wage coal, tobacco, and apparel industries. Its central location and low cost structure have helped the state's overall economic growth and have led to seven consecutive years of net in-migration to the state. The state's per capita personal income levels, however, have remained consistently below the national average. Since fiscal 1993, Kentucky's financial management has steadily improved. Results for fiscal 1998 were positive, with a general fund balance of $428 million. This was the fifth consecutive year of positive financial results for the state, due in part to the state's economic growth and a strong record of spending controls. The state's debt ratios, while declining, have remained high relative to other states. The 1998-2000 budget emphasizes spending for education, economic development and tax cuts and incentives to help further job growth and capital investments. LOUISIANA. Louisiana's economy has been historically cyclical due to its reliance on oil and gas production and petro-chemical products. The state has made some improvements towards a more diversified economy, however, with strong growth in its service sector, especially in healthcare and tourism services. Nonetheless, much of the state's recent economic growth has come from the upturn in the oil and gas sector. Gaming and construction have also contributed. Future growth could be limited by the state's dependence on the cyclical oil and gas industry, as well as below average wealth and income levels. Historically, Louisiana's main revenue sources, namely its sales tax, individual and corporate income tax, and severance and royalty taxes, have fluctuated with economic cycles and the oil and gas industry. This fluctuation has created instability and budget problems in the past. During the last several years, however, the state's financial position has stabilized somewhat. The state has had operating surpluses for the past five fiscal years ended 1997, a trend that, as of April 1998, was expected to continue for fiscal years 1998 and 1999. Over the past two years, the state also has made improvements towards controlling costs in its large health care system, especially Medicaid spending. The state remains vulnerable, however, to the volatility of its oil and gas industry. Its relatively high debt burden, unfunded pension liabilities, generally low reserves, and unfunded risk management claims for judgments against the state, which, as of April 1998, totaled $1.3 billion, could affect the state's performance in future years. MARYLAND. Maryland's economic base has been well-diversified. The state's leading employment and income sectors have been services (33%), trade (24%) and government (19%). Maryland's dependence on government has been larger than most other states due to its close proximity to Washington D.C., and has made Maryland vulnerable to federal budget cuts and downsizing. At the same time, the state's manufacturing sector (8%) has been smaller than most other states. Most recently, economic growth has come mainly from the business services sector. In 1998, job growth outpaced the national average for the first time in the 1990s. Maryland's financial performance has been historically strong. Contributing factors have included high per capita income levels, a well-educated workforce, an advanced infrastructure, and diversified employment opportunities. In each of the last five fiscal years, the state has generated operating surpluses while building its financial reserves. Debt service levels, while high relative to other states, also have remained manageable. Going forward, a potential area of financial stress may come from the state's recent 10% personal income tax reduction, which is to be phased in over five years. Taking the tax cut into consideration, budget forecasts begin to show an operating deficit in 2002. The state plans to use its reserves to manage shortfalls resulting from the tax cut. MISSOURI. Missouri historically has enjoyed a diversified economy that has tended to mirror the national economy. Employment and personal income growth, however, have been at or above the national average. In 1998, 34,000 new jobs were created in the state, led by government, financial services, insurance, real estate, service and retail trade sectors, and new businesses were up 55%. Personal income increased by 5.1% in 1998, equal to the national average. At the same time, the state's unemployment rate of 3.9% was below the national rate of 4.4%. Foreign exports, however, declined in 1998 for the first time this decade due to the Asian financial crisis. Despite declines in its manufacturing sector, trade and services have grown steadily and have more than offset the state's manufacturing losses. Missouri's low cost of living and highly skilled workforce have contributed to this growth and have made the state attractive to computer- and telecommunications-related companies. It has been estimated that the state's job growth will continue in the near term, although at a slower pace due to slow population growth and a tight labor force. These factors could raise wages and deter future economic growth. From a financial standpoint, Missouri's reluctance to rely heavily on borrowing to meet capital needs has resulted in a low debt burden, while sound financial management has resulted in a steadily improving financial position. The state's general fund has had a surplus in recent years. For fiscal 1999, increased expenditures for new prison construction, education and further tax reductions could reduce the state's future financial flexibility. NORTH CAROLINA. In recent years, North Carolina's economy has experienced strong growth. From 1994 to 1998, job growth was 3.3%, equal to the national rate. Below average business costs, a strong durable manufacturing sector, diverse agriculture, three prestigious universities, and access to ports for trade and commerce have all contributed to the state's recent economic strength. The economy has continued to diversify with less emphasis on textile and apparel manufacturing and more on services, finance and trade, with strong growth in the high-tech sector. Manufacturing has remained a significant part of the state's economy, however, and has created some vulnerability to recession. In 1998, unemployment was a low 3.3%, well below the national average. The state's low unemployment rate could create tight labor markets and constrain future economic growth. Over the past two years, North Carolina's outstanding debt has doubled due to new bond issues for highways and schools. Nonetheless, the state's debt burden has remained among the lowest in the nation. The state also has continued its recent trend of strong financial performance and conservative budgeting principles. The state ended fiscal 1998 with a surplus and was able to increase its reserves. Court ordered tax refunds and the need for increased school spending may put some pressure on the state's finances and could result in lower reserves in the near term. TEXAS. The Texas economy has continued to diversify and to move away from its dependence on the volatile oil and gas sector. The state's high-tech sector has become increasingly prominent, and, as of March 1999, was second behind only California in total jobs and advantages in cost of business. The construction, government and services industries also have experienced strong growth in recent years due in part to a relatively high rate of net migration to the state. Overall, Texas has added more than 1.1 million new jobs since 1994. While overall job growth has been strong, losses in the state's higher paying oil and gas and aerospace industries have resulted in slower, although still positive, personal income growth. On a per capita basis, income levels have remained below the national level. Further defense cutbacks could affect the state. Changes in the economic and financial stability of Mexico, the state's chief trade partner, also could adversely affect Texas, its economy and its financial performance. Financially, the state's performance has improved since the budget deficits of the mid-1980s when the oil and gas sector declined. Revenues have continued to increase as the state's economy has grown, resulting in a general fund surplus of $426 million for fiscal 1998. Although the 1998-1999 budget was balanced as of March 1999, the budget includes the use of almost all of the state's accumulated general fund surplus for property tax relief. The use of existing surpluses to fund tax cuts could create budget problems going forward, especially as the state may encounter spending pressures from its growing population. Since the state does not have a personal income tax, its reliance on cyclical sales taxes also could result in some budget instability. The state's debt burden has been relatively modest. In recent years, however, the state's debt position has grown. The state also has moved away from issuing debt designed to be self-supporting and towards issuing debt supported by the general revenue fund. Nonetheless, the state's debt has remained below the national average on a per capita basis. VIRGINIA. Virginia's economy has experienced strong growth in recent years, especially in the areas of business services, high-technology industries and retail trade. Growth in these areas has helped to offset federal government job losses caused by recent federal downsizing and budget cuts. The commonwealth's unemployment rate has remained one of the nation's lowest, while personal income levels have continued to exceed the national average. Historically, Virginia's debt levels have been low, although they have begun to increase due to some large highway and university construction projects. Revenues and expenses have likewise grown. Overall, financial results have been positive with surpluses in four of the past five fiscal years. Since 1995, the state has had to refund approximately $400 million of income tax collected on federal retiree benefits as a result of a court case. This amount was scheduled to be paid in full by fiscal year end 1999. In coming years, the state also will have to fund increased expenditures for education, as well as the elimination of its car tax. When fully phased in during fiscal 2003, the cost to the state of the car tax elimination is expected to be more than $2.6 billion. U.S. TERRITORIES Since each fund may invest a portion of its assets in municipal securities issued by U.S. territories, the ability of municipal issuers in U.S. territories to continue to make principal and interest payments also may affect a fund's performance. As with state municipal issuers, the ability to make these payments is dependent on economic, political and other conditions. Below is a discussion of certain conditions within some of the territories where the funds may be invested. It is not a complete analysis of every material fact that may affect the ability of issuers of U.S. territory municipal securities to meet their debt obligations or the economic or political conditions within the territories and is subject to change. It is based on data available to the funds from historically reliable sources, but it has not been independently verified by the funds. GUAM. Guam's economy has been heavily dependent on tourism. It has been especially dependent on Japanese tourism, which has made Guam vulnerable to fluctuations in the relationship between the U.S. dollar and the Japanese yen. The recent Asian economic crisis and Typhoon Paka, which hit Guam in December 1997, negatively affected both tourism and other economic activities in Guam and contributed to a decline of 1.8% in gross island product between 1997 and 1998. In the early to mid-1990s, Guam's financial position deteriorated due to a series of natural disasters that led to increased spending on top of already significant budget gaps. As a result, the government introduced a comprehensive financial plan in June 1995 to help balance the budget and reduce the general fund deficit by fiscal 1999. For fiscal 1998, however, Guam incurred a $21 million deficit and ended the year with a negative unreserved general fund balance of $158.9 million. Another deficit is expected in 1999. While Guam's debt burden has been manageable, Guam's ability to maintain current debt levels may be challenged in the near future. U.S. military downsizing has reduced the federal presence on the island and also may reduce federal support for infrastructure projects. At the same time, Guam has faced increasing pressure to improve its infrastructure to help generate economic development. Overall, as of May 20, 1999, S&P's outlook for Guam was negative due to Guam's continued weak financial position and inability to meet the goals of the financial plan. MARIANA ISLANDS. The Mariana Islands became a commonwealth in 1975. At that time, the U.S. government agreed to exempt the islands from federal minimum wage and immigration laws in an effort to help stimulate industry and the economy. The islands' minimum wage has been more than $2 per hour below the U.S. level and tens of thousands of workers have immigrated from various Asian countries to provide cheap labor for the islands' industries. Recently, the islands' tourism and apparel industries combined to help increase gross business receipts from $224 million in 1985 to $2 billion in 1996. PUERTO RICO. Overall, Moody's considered Puerto Rico's outlook stable as of January 1999. In recent years, Puerto Rico's financial performance has improved. Relatively strong revenue growth and more aggressive tax collection procedures resulted in a general fund surplus for fiscal 1998 (unaudited). For fiscal 1999, spending increases of 11% are budgeted, which may create an operating deficit and deplete the commonwealth's unreserved fund balance. Puerto Rico's debt levels have been high. Going forward, these levels may increase as Puerto Rico attempts to finance significant capital and infrastructure improvements. Puerto Rico also will need to address its large unfunded pension liability of more than $6 billion. Despite Puerto Rico's stable outlook, Puerto Rico may face challenges in the coming years with the 1996 passage of a bill eliminating section 936 of the Internal Revenue Code. This section has given certain U.S. corporations operating in Puerto Rico significant tax advantages. These incentives have helped considerably with Puerto Rico's economic growth, especially with the development of its manufacturing sector. U.S. firms that have benefited from these incentives have provided a significant portion of Puerto Rico's revenues, employment and deposits in local financial institutions. The section 936 incentives will be phased out over a 10-year period ending in 2006. It is hoped that this long phase-out period will give Puerto Rico sufficient time to lessen the potentially negative effects of section 936's elimination. Outstanding issues relating to the potential for a transition to statehood also may have broad implications for Puerto Rico and its financial and credit position. OFFICERS AND TRUSTEES - ------------------------------------------------------------------------------ The trust has a board of trustees. The board is responsible for the overall management of the trust, including general supervision and review of each fund's investment activities. The board, in turn, elects the officers of the trust who are responsible for administering the trust's day-to-day operations. The board also monitors each fund to ensure no material conflicts exist among share classes. While none is expected, the board will act appropriately to resolve any material conflict that may arise. The name, age and address of the officers and board members, as well as their affiliations, positions held with the trust, and principal occupations during the past five years are shown below. Frank H. Abbott, III (78) 1045 Sansome Street, San Francisco, CA 94111 TRUSTEE President and Director, Abbott Corporation (an investment company); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, MotherLode Gold Mines Consolidated (gold mining) and Vacu-Dry Co. (food processing). Harris J. Ashton (67) 191 Clapboard Ridge Road, Greenwich, CT 06830 TRUSTEE Director, RBC Holdings, Inc. (bank holding company) and Bar-S Foods (meat packing company); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, President, Chief Executive Officer and Chairman of the Board, General Host Corporation (nursery and craft centers). S. Joseph Fortunato (66) Park Avenue at Morris County, P.O. Box 1945 Morristown, NJ 07962-1945 TRUSTEE Member of the law firm of Pitney, Hardin, Kipp & Szuch; director or trustee, as the case may be, of 50 of the investment companies in the Franklin Templeton Group of Funds. Edith E. Holiday (47) 3239 38th Street, N.W., Washington, DC 20016 TRUSTEE Director, Amerada Hess Corporation (exploration and refining of natural gas) (1993-present), Hercules Incorporated (chemicals, fibers and resins) (1993-present), Beverly Enterprises, Inc. (health care) (1995-present) and H.J. Heinz Company (processed foods and allied products) (1994-present); director or trustee, as the case may be, of 24 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman (1995-1997) and Trustee (1993-1997), National Child Research Center, Assistant to the President of the United States and Secretary of the Cabinet (1990-1993), General Counsel to the United States Treasury Department (1989-1990), and Counselor to the Secretary and Assistant Secretary for Public Affairs and Public Liaison-United States Treasury Department (1988-1989). *Charles B. Johnson (66) 777 Mariners Island Blvd., San Mateo, CA 94404 CHAIRMAN OF THE BOARD AND TRUSTEE President, Chief Executive Officer and Director, Franklin Resources, Inc.; Chairman of the Board and Director, Franklin Advisers, Inc., Franklin Investment Advisory Services, Inc. and Franklin Templeton Distributors, Inc.; Director, Franklin/Templeton Investor Services, Inc. and Franklin Templeton Services, Inc.; officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 49 of the investment companies in the Franklin Templeton Group of Funds. *Rupert H. Johnson, Jr. (58) 77 Mariners Island Blvd., San Mateo, CA 94404 PRESIDENT AND TRUSTEE Executive Vice President and Director, Franklin Resources, Inc. and Franklin Templeton Distributors, Inc.; President and Director, Franklin Advisers, Inc. and Franklin Investment Advisory Services, Inc.; Senior Vice President, Franklin Advisory Services, LLC; Director, Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Frank W.T. LaHaye (70) 20833 Stevens Creek Blvd., Suite 102, Cupertino, CA 95014 TRUSTEE General Partner, Miller & LaHaye, which is the General Partner of Peregrine Ventures II (venture capital firm); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, Fischer Imaging Corporation (medical imaging systems), Digital Transmission Systems, Inc. (wireless communications) and Quarterdeck Corporation (software firm), and General Partner, Peregrine Associates, which was the General Partner of Peregrine Ventures (venture capital firm). Gordon S. Macklin (71) 8212 Burning Tree Road, Bethesda, MD 20817 TRUSTEE Director, Fund American Enterprises Holdings, Inc. (holding company), Martek Biosciences Corporation, MCI WorldCom (information services), MedImmune, Inc. (biotechnology), Spacehab, Inc. (aerospace services) and Real 3D (software); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman, White River Corporation (financial services) and Hambrecht and Quist Group (investment banking), and President, National Association of Securities Dealers, Inc. Harmon E. Burns (54) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President and Director, Franklin Resources, Inc., Franklin Templeton Distributors, Inc. and Franklin Templeton Services, Inc.; Executive Vice President, Franklin Advisers, Inc.; Director, Franklin Investment Advisory Services, Inc. and Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Martin L. Flanagan (39) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Senior Vice President and Chief Financial Officer, Franklin Resources, Inc., Franklin/Templeton Investor Services, Inc. and Franklin Mutual Advisers, LLC; Executive Vice President, Chief Financial Officer and Director, Templeton Worldwide, Inc.; Executive Vice President, Chief Operating Officer and Director, Templeton Investment Counsel, Inc.; Executive Vice President and Chief Financial Officer, Franklin Advisers, Inc.; Chief Financial Officer, Franklin Advisory Services, LLC and Franklin Investment Advisory Services, Inc.; President and Director, Franklin Templeton Services, Inc.; officer and/or director of some of the other subsidiaries of Franklin Resources, Inc.; and officer and/or director or trustee, as the case may be, of 52 of the investment companies in the Franklin Templeton Group of Funds. Deborah R. Gatzek (50) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND SECRETARY Senior Vice President and General Counsel, Franklin Resources, Inc.; Senior Vice President, Franklin Templeton Services, Inc. and Franklin Templeton Distributors, Inc.; Executive Vice President, Franklin Advisers, Inc.; Vice President, Franklin Advisory Services, LLC and Franklin Mutual Advisers, LLC; Vice President, Chief Legal Officer and Chief Operating Officer, Franklin Investment Advisory Services, Inc.; and officer of 53 of the investment companies in the Franklin Templeton Group of Funds. Thomas J. Kenny (36) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President, Franklin Advisers, Inc.; and officer of eight of the investment companies in the Franklin Templeton Group of Funds. Diomedes Loo-Tam (60) 777 Mariners Island Blvd., San Mateo, CA 94404 TREASURER AND PRINCIPAL ACCOUNTING OFFICER Senior Vice President, Franklin Templeton Services, Inc.; and officer of 32 of the investment companies in the Franklin Templeton Group of Funds. Edward V. McVey (61) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Senior Vice President and National Sales Manager, Franklin Templeton Distributors, Inc.; and officer of 28 of the investment companies in the Franklin Templeton Group of Funds. *This board member is considered an "interested person" under federal securities laws. Note: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers. The trust pays noninterested board members $1,450 per month plus $1,300 per meeting attended. Board members who serve on the audit committee of the trust and other funds in the Franklin Templeton Group of Funds receive a flat fee of $2,000 per committee meeting attended, a portion of which is allocated to the trust. Members of a committee are not compensated for any committee meeting held on the day of a board meeting. Noninterested board members also may serve as directors or trustees of other funds in the Franklin Templeton Group of Funds and may receive fees from these funds for their services. The fees payable to noninterested board members by the trust are subject to reductions resulting from fee caps limiting the amount of fees payable to board members who serve on other boards within the Franklin Templeton Group of Funds. The following table provides the total fees paid to noninterested board members by the trust and by the Franklin Templeton Group of Funds. NUMBER OF BOARDS IN TOTAL FEES THE FRANKLIN RECEIVED FROM TEMPLETON TOTAL FEES THE FRANKLIN GROUP RECEIVED TEMPLETON OF FUNDS FROM GROUP ON WHICH NAME THE TRUST 1 OF FUNDS 2 EACH SERVES 3 - ---------------------------------------------------------------------- Frank H. Abbott, III $25,675 $159,051 27 Harris J. Ashton $26,390 $361,157 48 S. Joseph Fortunato $25,097 $367,835 50 Edith E. Holiday $28,650 $211,400 24 Frank W.T. LaHaye $26,975 $163,753 27 Gordon S. Macklin $26,390 $361,157 48 1. For the fiscal year ended February 28, 1999. During the period from March 1, 1998, through May 31, 1998, fees at the rate of $1,300 per month plus $1,300 per board meeting attended were in effect. 2. For the calendar year ended December 31, 1998. 3. We base the number of boards on the number of registered investment companies in the Franklin Templeton Group of Funds. This number does not include the total number of series or funds within each investment company for which the board members are responsible. The Franklin Templeton Group of Funds currently includes 54 registered investment companies, with approximately 163 U.S. based funds or series. Noninterested board members are reimbursed for expenses incurred in connection with attending board meetings, paid pro rata by each fund in the Franklin Templeton Group of Funds for which they serve as director or trustee. No officer or board member received any other compensation, including pension or retirement benefits, directly or indirectly from the fund or other funds in the Franklin Templeton Group of Funds. Certain officers or board members who are shareholders of Franklin Resources, Inc. may be deemed to receive indirect remuneration by virtue of their participation, if any, in the fees paid to its subsidiaries. Board members historically have followed a policy of having substantial investments in one or more of the funds in the Franklin Templeton Group of Funds, as is consistent with their individual financial goals. In February 1998, this policy was formalized through adoption of a requirement that each board member invest one-third of fees received for serving as a director or trustee of a Templeton fund in shares of one or more Templeton funds and one-third of fees received for serving as a director or trustee of a Franklin fund in shares of one or more Franklin funds until the value of such investments equals or exceeds five times the annual fees paid such board member. Investments in the name of family members or entities controlled by a board member constitute fund holdings of such board member for purposes of this policy, and a three year phase-in period applies to such investment requirements for newly elected board members. In implementing such policy, a board member's fund holdings existing on February 27, 1998, are valued as of such date with subsequent investments valued at cost. MANAGEMENT AND OTHER SERVICES - ------------------------------------------------------------------------------ MANAGER AND SERVICES PROVIDED Each fund's manager is Franklin Advisers, Inc. The manager is a wholly owned subsidiary of Franklin Resources, Inc. (Resources), a publicly owned company engaged in the financial services industry through its subsidiaries. Charles B. Johnson and Rupert H. Johnson, Jr. are the principal shareholders of Resources. The manager provides investment research and portfolio management services, and selects the securities for each fund to buy, hold or sell. The manager's extensive research activities include, as appropriate, traveling to meet with issuers and to review project sites. The manager also selects the brokers who execute the funds' portfolio transactions. The manager provides periodic reports to the board, which reviews and supervises the manager's investment activities. To protect the funds, the manager and its officers, directors and employees are covered by fidelity insurance. The manager and its affiliates manage numerous other investment companies and accounts. The manager may give advice and take action with respect to any of the other funds it manages, or for its own account, that may differ from action taken by the manager on behalf of each fund. Similarly, with respect to each fund, the manager is not obligated to recommend, buy or sell, or to refrain from recommending, buying or selling any security that the manager and access persons, as defined by applicable federal securities laws, may buy or sell for its or their own account or for the accounts of any other fund. The manager is not obligated to refrain from investing in securities held by the fund or other funds it manages. Of course, any transactions for the accounts of the manager and other access persons will be made in compliance with the funds' code of ethics. Under the funds' code of ethics, employees of the Franklin Templeton Group who are access persons may engage in personal securities transactions subject to the following general restrictions and procedures: (i) the trade must receive advance clearance from a compliance officer and must be completed by the close of the business day following the day clearance is granted; (ii) copies of all brokerage confirmations and statements must be sent to a compliance officer; (iii) all brokerage accounts must be disclosed on an annual basis; and (iv) access persons involved in preparing and making investment decisions must, in addition to (i), (ii) and (iii) above, file annual reports of their securities holdings each January and inform the compliance officer (or other designated personnel) if they own a security that is being considered for a fund or other client transaction or if they are recommending a security in which they have an ownership interest for purchase or sale by a fund or other client. MANAGEMENT FEES Each fund pays the manager a fee equal to a monthly rate of: o 5/96 of 1% of the value of its net assets up to and including $100 million; and o 1/24 of 1% of the value of its net assets over $100 million up to and including $250 million; and o 9/240 of 1% of the value of its net assets in excess of $250 million. The fee is computed at the close of business on the last business day of each month according to the terms of the management agreement. Each class of a fund's shares pays its proportionate share of the fee. For the last three fiscal years ended February 28, the funds paid the following management fees: MANAGEMENT FEES PAID ($) -------------------------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------ Alabama Fund 1,332,672 1,189,527 1,079,285 Florida Fund 8,253,117 7,419,693 6,567,507 Georgia Fund 990,149 872,451 812,505 Kentucky Fund1 143,286 81,200 66,255 Louisiana Fund 908,906 758,170 692,158 Maryland Fund 1,369,242 1,166,952 1,033,178 Missouri Fund 1,860,465 1,574,188 1,416,882 North Carolina Fund 1,834,435 1,566,067 1,410,760 Texas Fund 786,294 770,725 762,188 Virginia Fund 1,958,381 1,689,780 1,519,947 1. For the fiscal years ended February 28, 1999, 1998 and 1997, management fees, before any advance waiver, totaled $377,311, $304,904 and $260,610, respectively. Under an agreement by the manager to limit its fees, the fund paid the management fees shown. ADMINISTRATOR AND SERVICES PROVIDED Franklin Templeton Services, Inc. (FT Services) has an agreement with the manager to provide certain administrative services and facilities for each fund. FT Services is wholly owned by Resources and is an affiliate of the funds' manager and principal underwriter. The administrative services FT Services provides include preparing and maintaining books, records, and tax and financial reports, and monitoring compliance with regulatory requirements. ADMINISTRATION FEES The manager pays FT Services a monthly fee equal to an annual rate of: o 0.15% of each fund's average daily net assets up to $200 million; o 0.135% of average daily net assets over $200 million up to $700 million; o 0.10% of average daily net assets over $700 million up to $1.2 billion; and o 0.075% of average daily net assets over $1.2 billion. During the last three fiscal years ended February 28, the manager paid FT Services the following administration fees: ADMINISTRATION FEES PAID ($) ----------------------------------------------------- 1999 1998 1997 1 - ------------------------------------------------------------------------------ Alabama Fund 353,966 315,821 121,584 Florida Fund 1,902,604 1,761,352 691,407 Georgia Fund 257,705 223,366 88,065 Kentucky Fund 89,842 72,518 26,745 Louisiana Fund 233,010 188,768 72,596 Maryland Fund 362,711 309,059 116,248 Missouri Fund 508,048 424,634 163,365 North Carolina Fund 501,620 422,191 161,088 Texas Fund 198,223 193,355 79,386 Virginia Fund 539,321 458,682 174,841 1. For the period from October 1, 1996, through February 28, 1997. SHAREHOLDER SERVICING AND TRANSFER AGENT Franklin/Templeton Investor Services, Inc. (Investor Services) is each fund's shareholder servicing agent and acts as the fund's transfer agent and dividend-paying agent. Investor Services is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Please send all correspondence to Investor Services to P.O. Box 997151, Sacramento, CA 95899-9983. For its services, Investor Services receives a fixed fee per account. Each fund also will reimburse Investor Services for certain out-of-pocket expenses, which may include payments by Investor Services to entities, including affiliated entities, that provide sub-shareholder services, recordkeeping and/or transfer agency services to beneficial owners of the fund. The amount of reimbursements for these services per benefit plan participant fund account per year will not exceed the per account fee payable by the fund to Investor Services in connection with maintaining shareholder accounts. CUSTODIAN Bank of New York, Mutual Funds Division, 90 Washington Street, New York, NY 10286, acts as custodian of each fund's securities and other assets. AUDITOR PricewaterhouseCoopers LLP, 333 Market Street, San Francisco, CA 94105, is the funds' independent auditor. The auditor gives an opinion on the financial statements included in the trust's Annual Report to Shareholders and reviews the trust's registration statement filed with the U.S. Securities and Exchange Commission (SEC). PORTFOLIO TRANSACTIONS - ------------------------------------------------------------------------------ Since most purchases by the funds are principal transactions at net prices, the funds incurs little or no brokerage costs. Each fund deals directly with the selling or buying principal or market maker without incurring charges for the services of a broker on its behalf, unless it is determined that a better price or execution may be obtained by using the services of a broker. Purchases of portfolio securities from underwriters will include a commission or concession paid by the issuer to the underwriter, and purchases from dealers will include a spread between the bid and ask prices. As a general rule, the funds do not buy securities in underwritings where they are given no choice, or only limited choice, in the designation of dealers to receive the commission. The funds seek to obtain prompt execution of orders at the most favorable net price. Transactions may be directed to dealers in return for research and statistical information, as well as for special services provided by the dealers in the execution of orders. It is not possible to place a dollar value on the special executions or on the research services the manager receives from dealers effecting transactions in portfolio securities. The allocation of transactions in order to obtain additional research services allows the manager to supplement its own research and analysis activities and to receive the views and information of individuals and research staffs of other securities firms. As long as it is lawful and appropriate to do so, the manager and its affiliates may use this research and data in their investment advisory capacities with other clients. If the funds' officers are satisfied that the best execution is obtained, the sale of fund shares, as well as shares of other funds in the Franklin Templeton Group of Funds, also may be considered a factor in the selection of broker-dealers to execute the funds' portfolio transactions. If purchases or sales of securities of the funds and one or more other investment companies or clients supervised by the manager are considered at or about the same time, transactions in these securities will be allocated among the several investment companies and clients in a manner deemed equitable to all by the manager, taking into account the respective sizes of the funds and the amount of securities to be purchased or sold. In some cases this procedure could have a detrimental effect on the price or volume of the security so far as the funds are concerned. In other cases it is possible that the ability to participate in volume transactions may improve execution and reduce transaction costs to the funds. During the fiscal years ended February 28, 1999, 1998 and 1997, the funds did not pay any brokerage commissions. As of February 28, 1999, the funds did not own securities of their regular broker-dealers. DISTRIBUTIONS AND TAXES - ------------------------------------------------------------------------------ The funds calculate dividends and capital gains the same way for each class. The amount of any income dividends per share will differ, however, generally due to the difference in the distribution and service (Rule 12b-1) fees of each class. The funds do not pay "interest" or guarantee any fixed rate of return on an investment in their shares. DISTRIBUTIONS OF NET INVESTMENT INCOME Each fund receives income generally in the form of interest on its investments. This income, less expenses incurred in the operation of the fund, constitutes the fund's net investment income from which dividends may be paid to you. By meeting certain requirements of the Internal Revenue Code, the funds have qualified and continue to qualify to pay exempt-interest dividends to you. These dividends are derived from interest income exempt from regular federal income tax, and are not subject to regular federal income tax when they are distributed to you. In addition, to the extent that exempt-interest dividends are derived from interest on obligations of a state or its political subdivisions, or from interest on qualifying U.S. territorial obligations (including qualifying obligations of Puerto Rico, the U.S. Virgin Islands or Guam), they also will be exempt from that state's personal income taxes. Most states generally do not grant tax-free treatment to interest on state and municipal securities of other states. The funds may earn taxable income on any temporary investments, on the discount from stripped obligations or their coupons, on income from securities loans or other taxable transactions, or on ordinary income derived from the sale of market discount bonds. Any fund distributions from such income will be taxable to you as ordinary income, whether you receive them in cash or in additional shares. DISTRIBUTIONS OF CAPITAL GAINS The funds may derive capital gains and losses in connection with sales or other dispositions of their portfolio securities. Distributions from net short-term capital gains will be taxable to you as ordinary income. Distributions from net long-term capital gains will be taxable to you as long-term capital gain, regardless of how long you have held your shares in a fund. Any net capital gains realized by a fund generally will be distributed once each year, and may be distributed more frequently, if necessary, in order to reduce or eliminate excise or income taxes on the fund. INFORMATION ON THE TAX CHARACTER OF DISTRIBUTIONS The funds will inform you of the amount of your ordinary income dividends and capital gains distributions at the time they are paid, and will advise you of their tax status for federal income tax purposes shortly after the close of each calendar year, including the portion of the distributions that on average comprise taxable income or interest income that is a tax preference item under the alternative minimum tax. If you have not held fund shares for a full year, a fund may designate and distribute to you, as taxable, tax-exempt or tax preference income, a percentage of income that is not equal to the actual amount of such income earned during the period of your investment in the fund. ELECTION TO BE TAXED AS A REGULATED INVESTMENT COMPANY Each fund has elected to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code, has qualified as such for its most recent fiscal year, and intends to so qualify during the current fiscal year. As regulated investment companies, the funds generally pay no federal income tax on the income and gains they distribute to you. The board reserves the right not to maintain the qualification of a fund as a regulated investment company if it determines such course of action to be beneficial to shareholders. In such case, a fund will be subject to federal, and possibly state, corporate taxes on its taxable income and gains, and distributions to you will be taxed as ordinary dividend income to the extent of the fund's earnings and profits. EXCISE TAX DISTRIBUTION REQUIREMENTS To avoid federal excise taxes, the Internal Revenue Code requires each fund to distribute to you by December 31 of each year, at a minimum, the following amounts: 98% of its taxable ordinary income earned during the calendar year; 98% of its capital gain net income earned during the twelve month period ending October 31; and 100% of any undistributed amounts from the prior year. Each fund intends to declare and pay these amounts in December (or in January that are treated by you as received in December) to avoid these excise taxes, but can give no assurances that its distributions will be sufficient to eliminate all taxes. REDEMPTION OF FUND SHARES Redemptions and exchanges of fund shares are taxable transactions for federal and state income tax purposes. If you redeem your fund shares, or exchange your fund shares for shares of a different Franklin Templeton Fund, the IRS will require that you report a gain or loss on your redemption or exchange. If you hold your shares as a capital asset, the gain or loss that you realize will be capital gain or loss and will be long-term or short-term, generally depending on how long you hold your shares. Any loss incurred on the redemption or exchange of shares held for six months or less will be disallowed to the extent of any exempt-interest dividends distributed to you with respect to your fund shares and any remaining loss will be treated as a long-term capital loss to the extent of any long-term capital gains distributed to you by the fund on those shares. All or a portion of any loss that you realize upon the redemption of your fund shares will be disallowed to the extent that you buy other shares in the fund (through reinvestment of dividends or otherwise) within 30 days before or after your share redemption. Any loss disallowed under these rules will be added to your tax basis in the new shares you buy. DEFERRAL OF BASIS If you redeem some or all of your shares in a fund, and then reinvest the sales proceeds in the fund or in another Franklin Templeton Fund within 90 days of buying the original shares, the sales charge that would otherwise apply to your reinvestment may be reduced or eliminated. The IRS will require you to report gain or loss on the redemption of your original shares in a fund. In doing so, all or a portion of the sales charge that you paid for your original shares in a fund will be excluded from your tax basis in the shares sold (for the purpose of determining gain or loss upon the sale of such shares). The portion of the sales charge excluded will equal the amount that the sales charge is reduced on your reinvestment. Any portion of the sales charge excluded from your tax basis in the shares sold will be added to the tax basis of the shares you acquire from your reinvestment. DIVIDENDS-RECEIVED DEDUCTION FOR CORPORATIONS Because each fund's income consists of interest rather than dividends, no portion of its distributions generally will be eligible for the corporate dividends-received deduction. None of the dividends paid by the funds for the most recent fiscal year qualified for such deduction, and it is anticipated that none of the current year's dividends will so qualify. INVESTMENT IN COMPLEX SECURITIES Each fund may invest in complex securities. These investments may be subject to numerous special and complex tax rules. These rules could affect whether gains and losses recognized by a fund are treated as ordinary income or capital gain, accelerate the recognition of income to a fund and/or defer a fund's ability to recognize losses. In turn, these rules may affect the amount, timing or character of the income distributed to you by a fund. TREATMENT OF PRIVATE ACTIVITY BOND INTEREST Interest on certain private activity bonds, while still exempt from regular federal income tax, is a preference item for taxpayers when determining their alternative minimum tax under the Internal Revenue Code and under the income tax provisions of several states. Private activity bond interest could subject you to or increase your liability under federal and state alternative minimum taxes, depending on your individual or corporate tax position. Persons who are defined in the Internal Revenue Code as substantial users (or persons related to such users) of facilities financed by private activity bonds should consult with their tax advisors before buying fund shares. ORGANIZATION, VOTING RIGHTS AND PRINCIPAL HOLDERS - ------------------------------------------------------------------------------ Each fund is a series of Franklin Tax-Free Trust, an open-end management investment company, commonly called a mutual fund. The trust was organized as a Massachusetts business trust in September 1984, and is registered with the SEC. As a shareholder of a Massachusetts business trust, you could, under certain circumstances, be held personally liable as a partner for its obligations. The Agreement and Declaration of Trust, however, contains an express disclaimer of shareholder liability for acts or obligations of the fund. The Declaration of Trust also provides for indemnification and reimbursement of expenses out of the fund's assets if you are held personally liable for obligations of the fund. The Declaration of Trust provides that the fund shall, upon request, assume the defense of any claim made against you for any act or obligation of the fund and satisfy any judgment thereon. All such rights are limited to the assets of the fund. The Declaration of Trust further provides that the fund may maintain appropriate insurance (for example, fidelity bonding and errors and omissions insurance) for the protection of the fund, its shareholders, trustees, officers, employees and agents to cover possible tort and other liabilities. Furthermore, the activities of the fund as an investment company, as distinguished from an operating company, would not likely give rise to liabilities in excess of the fund's total assets. Thus, the risk that you would incur financial loss on account of shareholder liability is limited to the unlikely circumstance in which both inadequate insurance exists and the fund itself is unable to meet its obligations. Each fund, except for the Kentucky Fund, currently offers two classes of shares, Class A and Class C. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. The full title of each class is: o Franklin Alabama Tax-Free Income Fund - Class A o Franklin Alabama Tax-Free Income Fund - Class C o Franklin Florida Tax-Free Income Fund - Class A o Franklin Florida Tax-Free Income Fund - Class C o Franklin Georgia Tax-Free Income Fund - Class A o Franklin Georgia Tax-Free Income Fund - Class C o Franklin Louisiana Tax-Free Income Fund - Class A o Franklin Louisiana Tax-Free Income Fund - Class C o Franklin Maryland Tax-Free Income Fund - Class A o Franklin Maryland Tax-Free Income Fund - Class C o Franklin Missouri Tax-Free Income Fund - Class A o Franklin Missouri Tax-Free Income Fund - Class C o Franklin North Carolina Tax-Free Income Fund - Class A o Franklin North Carolina Tax-Free Income Fund - Class C o Franklin Texas Tax-Free Income Fund - Class A o Franklin Texas Tax-Free Income Fund - Class C o Franklin Virginia Tax-Free Income Fund - Class A o Franklin Virginia Tax-Free Income Fund - Class C The Kentucky Fund offers only one share class. Because its sales charge structure and Rule 12b-1 plan are similar to those of Class A shares, shares of the Kentucky Fund are considered Class A shares for redemption, exchange and other purposes. The funds may offer additional classes of shares in the future. Shares of each class represent proportionate interests in each fund's assets. On matters that affect the fund as a whole, each class has the same voting and other rights and preferences as any other class. On matters that affect only one class, only shareholders of that class may vote. Each class votes separately on matters affecting only that class, or expressly required to be voted on separately by state or federal law. Shares of each class of a series have the same voting and other rights and preferences as the other classes and series of the trust for matters that affect the trust as a whole. Additional series may be offered in the future. The trust has noncumulative voting rights. For board member elections, this gives holders of more than 50% of the shares voting the ability to elect all of the members of the board. If this happens, holders of the remaining shares voting will not be able to elect anyone to the board. The trust does not intend to hold annual shareholder meetings. The trust or a series of the trust may hold special meetings, however, for matters requiring shareholder approval. A meeting may be called by the board to consider the removal of a board member if requested in writing by shareholders holding at least 10% of the outstanding shares. In certain circumstances, we are required to help you communicate with other shareholders about the removal of a board member. A special meeting also may be called by the board in its discretion. As of April 12, 1999, the principal shareholders of the funds, beneficial or of record, were: NAME AND ADDRESS SHARE CLASS PERCENTAGE (%) - ------------------------------------------------------------------------------ TEXAS FUND Family Ltd. Partnership Alo Family Limited 4512 Teas St. Bellaire, TX 77401-4223 Class C 6.15 PaineWebber For the Benefit of Timothy A. Costello 9501 Bell Mountain Dr. Austin, TX 78730-2712 Class C 5.98 From time to time, the number of fund shares held in the "street name" accounts of various securities dealers for the benefit of their clients or in centralized securities depositories may exceed 5% of the total shares outstanding. As of April 12, 1999, the officers and board members, as a group, owned of record and beneficially less than 1% of the outstanding shares of each fund and class. The board members may own shares in other funds in the Franklin Templeton Group of Funds. BUYING AND SELLING SHARES - ------------------------------------------------------------------------------ The fund continuously offers its shares through securities dealers who have an agreement with Franklin Templeton Distributors, Inc. (Distributors). A securities dealer includes any financial institution that, either directly or through affiliates, has an agreement with Distributors to handle customer orders and accounts with the fund. This reference is for convenience only and does not indicate a legal conclusion of capacity. Banks and financial institutions that sell shares of the fund may be required by state law to register as securities dealers. For investors outside the U.S., the offering of fund shares may be limited in many jurisdictions. An investor who wishes to buy shares of the fund should determine, or have a broker-dealer determine, the applicable laws and regulations of the relevant jurisdiction. Investors are responsible for compliance with tax, currency exchange or other regulations applicable to redemption and purchase transactions in any jurisdiction to which they may be subject. Investors should consult appropriate tax and legal advisors to obtain information on the rules applicable to these transactions. All checks, drafts, wires and other payment mediums used to buy or sell shares of the fund must be denominated in U.S. dollars. We may, in our sole discretion, either (a) reject any order to buy or sell shares denominated in any other currency or (b) honor the transaction or make adjustments to your account for the transaction as of a date and with a foreign currency exchange factor determined by the drawee bank. When you buy shares, if you submit a check or a draft that is returned unpaid to the fund we may impose a $10 charge against your account for each returned item. INITIAL SALES CHARGES The maximum initial sales charge is 4.25% for Class A and 1% for Class C. The initial sales charge for Class A shares may be reduced for certain large purchases, as described in the prospectus. We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases. The Franklin Templeton Funds include the U.S. registered mutual funds in the Franklin Group of Funds(R) and the Templeton Group of Funds except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. CUMULATIVE QUANTITY DISCOUNT. For purposes of calculating the sales charge on Class A shares, you may combine the amount of your current purchase with the cost or current value, whichever is higher, of your existing shares in the Franklin Templeton Funds. You also may combine the shares of your spouse, children under the age of 21 or grandchildren under the age of 21. If you are the sole owner of a company, you also may add any company accounts, including retirement plan accounts. LETTER OF INTENT (LOI). You may buy Class A shares at a reduced sales charge by completing the letter of intent section of your account application. A letter of intent is a commitment by you to invest a specified dollar amount during a 13 month period. The amount you agree to invest determines the sales charge you pay. By completing the letter of intent section of the application, you acknowledge and agree to the following: o You authorize Distributors to reserve 5% of your total intended purchase in Class A shares registered in your name until you fulfill your LOI. Your periodic statements will include the reserved shares in the total shares you own, and we will pay or reinvest dividend and capital gain distributions on the reserved shares according to the distribution option you have chosen. o You give Distributors a security interest in the reserved shares and appoint Distributors as attorney-in-fact. o Distributors may sell any or all of the reserved shares to cover any additional sales charge if you do not fulfill the terms of the LOI. o Although you may exchange your shares, you may not sell reserved shares until you complete the LOI or pay the higher sales charge. After you file your LOI with the fund, you may buy Class A shares at the sales charge applicable to the amount specified in your LOI. Sales charge reductions based on purchases in more than one Franklin Templeton Fund will be effective only after notification to Distributors that the investment qualifies for a discount. Any Class A purchases you made within 90 days before you filed your LOI also may qualify for a retroactive reduction in the sales charge. If you file your LOI with the fund before a change in the fund's sales charge, you may complete the LOI at the lower of the new sales charge or the sales charge in effect when the LOI was filed. Your holdings in the Franklin Templeton Funds acquired more than 90 days before you filed your LOI will be counted towards the completion of the LOI, but they will not be entitled to a retroactive reduction in the sales charge. Any redemptions you make during the 13 month period will be subtracted from the amount of the purchases for purposes of determining whether the terms of the LOI have been completed. If the terms of your LOI are met, the reserved shares will be deposited to an account in your name or delivered to you or as you direct. If the amount of your total purchases, less redemptions, is more than the amount specified in your LOI and is an amount that would qualify for a further sales charge reduction, a retroactive price adjustment will be made by Distributors and the securities dealer through whom purchases were made. The price adjustment will be made on purchases made within 90 days before and on those made after you filed your LOI and will be applied towards the purchase of additional shares at the offering price applicable to a single purchase or the dollar amount of the total purchases. If the amount of your total purchases, less redemptions, is less than the amount specified in your LOI, the sales charge will be adjusted upward, depending on the actual amount purchased (less redemptions) during the period. You will need to send Distributors an amount equal to the difference in the actual dollar amount of sales charge paid and the amount of sales charge that would have applied to the total purchases if the total of the purchases had been made at one time. Upon payment of this amount, the reserved shares held for your account will be deposited to an account in your name or delivered to you or as you direct. If within 20 days after written request the difference in sales charge is not paid, we will redeem an appropriate number of reserved shares to realize the difference. If you redeem the total amount in your account before you fulfill your LOI, we will deduct the additional sales charge due from the sale proceeds and forward the balance to you. GROUP PURCHASES. If you are a member of a qualified group, you may buy Class A shares at a reduced sales charge that applies to the group as a whole. The sales charge is based on the combined dollar value of the group members' existing investments, plus the amount of the current purchase. A qualified group is one that: o Was formed at least six months ago, o Has a purpose other than buying fund shares at a discount, o Has more than 10 members, o Can arrange for meetings between our representatives and group members, o Agrees to include Franklin Templeton Fund sales and other materials in publications and mailings to its members at reduced or no cost to Distributors, o Agrees to arrange for payroll deduction or other bulk transmission of investments to the fund, and o Meets other uniform criteria that allow Distributors to achieve cost savings in distributing shares. WAIVERS FOR INVESTMENTS FROM CERTAIN PAYMENTS. Class A shares may be purchased without an initial sales charge or contingent deferred sales charge (CDSC) by investors who reinvest within 365 days: o Dividend and capital gain distributions from any Franklin Templeton Fund. The distributions generally must be reinvested in the same share class. Certain exceptions apply, however, to Class C shareholders who chose to reinvest their distributions in Class A shares of the fund before November 17, 1997, and to Advisor Class or Class Z shareholders of a Franklin Templeton Fund who may reinvest their distributions in the fund's Class A shares. This waiver category also applies to Class C shares. o Dividend or capital gain distributions from a real estate investment trust (REIT) sponsored or advised by Franklin Properties, Inc. o Annuity payments received under either an annuity option or from death benefit proceeds, if the annuity contract offers as an investment option the Franklin Valuemark Funds or the Templeton Variable Products Series Fund. You should contact your tax advisor for information on any tax consequences that may apply. o Redemption proceeds from a repurchase of shares of Franklin Floating Rate Trust, if the shares were continuously held for at least 12 months. If you immediately placed your redemption proceeds in a Franklin Bank CD or a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date the CD matures, including any rollover, or the date you redeem your money fund shares. o Redemption proceeds from the sale of Class A shares of any of the Templeton Global Strategy Funds if you are a qualified investor. If you paid a CDSC when you redeemed your Class A shares from a Templeton Global Strategy Fund, a new CDSC will apply to your purchase of fund shares and the CDSC holding period will begin again. We will, however, credit your fund account with additional shares based on the CDSC you previously paid and the amount of the redemption proceeds that you reinvest. If you immediately placed your redemption proceeds in a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date they are redeemed from the money fund. WAIVERS FOR CERTAIN INVESTORS. Class A shares also may be purchased without an initial sales charge or CDSC by various individuals and institutions due to anticipated economies in sales efforts and expenses, including: o Trust companies and bank trust departments agreeing to invest in Franklin Templeton Funds over a 13 month period at least $1 million of assets held in a fiduciary, agency, advisory, custodial or similar capacity and over which the trust companies and bank trust departments or other plan fiduciaries or participants, in the case of certain retirement plans, have full or shared investment discretion. We will accept orders for these accounts by mail accompanied by a check or by telephone or other means of electronic data transfer directly from the bank or trust company, with payment by federal funds received by the close of business on the next business day following the order. o Any state or local government or any instrumentality, department, authority or agency thereof that has determined the fund is a legally permissible investment and that can only buy fund shares without paying sales charges. Please consult your legal and investment advisors to determine if an investment in the fund is permissible and suitable for you and the effect, if any, of payments by the fund on arbitrage rebate calculations. o Broker-dealers, registered investment advisors or certified financial planners who have entered into an agreement with Distributors for clients participating in comprehensive fee programs o Qualified registered investment advisors who buy through a broker-dealer or service agent who has entered into an agreement with Distributors o Registered securities dealers and their affiliates, for their investment accounts only o Current employees of securities dealers and their affiliates and their family members, as allowed by the internal policies of their employer o Officers, trustees, directors and full-time employees of the Franklin Templeton Funds or the Franklin Templeton Group, and their family members, consistent with our then-current policies o Any investor who is currently a Class Z shareholder of Franklin Mutual Series Fund Inc. (Mutual Series), or who is a former Mutual Series Class Z shareholder who had an account in any Mutual Series fund on October 31, 1996, or who sold his or her shares of Mutual Series Class Z within the past 365 days o Investment companies exchanging shares or selling assets pursuant to a merger, acquisition or exchange offer o Accounts managed by the Franklin Templeton Group o Certain unit investment trusts and their holders reinvesting distributions from the trusts SALES IN TAIWAN. Under agreements with certain banks in Taiwan, Republic of China, each fund's shares are available to these banks' trust accounts without a sales charge. The banks may charge service fees to their customers who participate in the trusts. A portion of these service fees may be paid to Distributors or one of its affiliates to help defray expenses of maintaining a service office in Taiwan, including expenses related to local literature fulfillment and communication facilities. Each fund's Class A shares may be offered to investors in Taiwan through securities advisory firms known locally as Securities Investment Consulting Enterprises. In conformity with local business practices in Taiwan, Class A shares may be offered with the following schedule of sales charges: SIZE OF PURCHASE - U.S. DOLLARS SALES CHARGE (%) - ------------------------------------------------------------------------------ Under $30,000 3.0 $30,000 but less than $100,000 2.0 $100,000 but less than $400,000 1.0 $400,000 or more 0 DEALER COMPENSATION Securities dealers may at times receive the entire sales charge. A securities dealer who receives 90% or more of the sales charge may be deemed an underwriter under the Securities Act of 1933, as amended. Financial institutions or their affiliated brokers may receive an agency transaction fee in the percentages indicated in the dealer compensation table in the funds' prospectus. Distributors may pay the following commissions, out of its own resources, to securities dealers who initiate and are responsible for purchases of Class A shares of $1 million or more: 0.75% on sales of $1 million to $2 million, plus 0.60% on sales over $2 million to $3 million, plus 0.50% on sales over $3 million to $50 million, plus 0.25% on sales over $50 million to $100 million, plus 0.15% on sales over $100 million. These breakpoints are reset every 12 months for purposes of additional purchases. Distributors and/or its affiliates provide financial support to various securities dealers that sell shares of the Franklin Templeton Group of Funds. This support is based primarily on the amount of sales of fund shares. The amount of support may be affected by: total sales; net sales; levels of redemptions; the proportion of a securities dealer's sales and marketing efforts in the Franklin Templeton Group of Funds; a securities dealer's support of, and participation in, Distributors' marketing programs; a securities dealer's compensation programs for its registered representatives; and the extent of a securities dealer's marketing programs relating to the Franklin Templeton Group of Funds. Financial support to securities dealers may be made by payments from Distributors' resources, from Distributors' retention of underwriting concessions and, in the case of funds that have Rule 12b-1 plans, from payments to Distributors under such plans. In addition, certain securities dealers may receive brokerage commissions generated by fund portfolio transactions in accordance with the rules of the National Association of Securities Dealers, Inc. Distributors routinely sponsors due diligence meetings for registered representatives during which they receive updates on various Franklin Templeton Funds and are afforded the opportunity to speak with portfolio managers. Invitation to these meetings is not conditioned on selling a specific number of shares. Those who have shown an interest in the Franklin Templeton Funds, however, are more likely to be considered. To the extent permitted by their firm's policies and procedures, registered representatives' expenses in attending these meetings may be covered by Distributors. CONTINGENT DEFERRED SALES CHARGE (CDSC) If you invest $1 million or more in Class A shares, either as a lump sum or through our cumulative quantity discount or letter of intent programs, a CDSC may apply on any shares you sell within 12 months of purchase. For Class C shares, a CDSC may apply if you sell your shares within 18 months of purchase. The CDSC is 1% of the value of the shares sold or the net asset value at the time of purchase, whichever is less. CDSC WAIVERS. The CDSC for any share class generally will be waived for: o Account fees o Redemptions of Class A shares by investors who purchased $1 million or more without an initial sales charge if the securities dealer of record waived its commission in connection with the purchase o Redemptions by the fund when an account falls below the minimum required account size o Redemptions following the death of the shareholder or beneficial owner o Redemptions through a systematic withdrawal plan set up before February 1, 1995 o Redemptions through a systematic withdrawal plan set up on or after February 1, 1995, up to 1% monthly, 3% quarterly, 6% semiannually or 12% annually of your account's net asset value depending on the frequency of your plan EXCHANGE PRIVILEGE If you request the exchange of the total value of your account, accrued but unpaid income dividends and capital gain distributions will be reinvested in the fund at net asset value on the date of the exchange, and then the entire share balance will be exchanged into the new fund. Backup withholding and information reporting may apply. If a substantial number of shareholders should, within a short period, sell their fund shares under the exchange privilege, the fund might have to sell portfolio securities it might otherwise hold and incur the additional costs related to such transactions. On the other hand, increased use of the exchange privilege may result in periodic large inflows of money. If this occurs, it is each fund's general policy to initially invest this money in short-term, tax-exempt municipal securities, unless it is believed that attractive investment opportunities consistent with the fund's investment goals exist immediately. This money will then be withdrawn from the short-term, tax-exempt municipal securities and invested in portfolio securities in as orderly a manner as is possible when attractive investment opportunities arise. The proceeds from the sale of shares of an investment company are generally not available until the seventh day following the sale. The funds you are seeking to exchange into may delay issuing shares pursuant to an exchange until that seventh day. The sale of fund shares to complete an exchange will be effected at net asset value at the close of business on the day the request for exchange is received in proper form. SYSTEMATIC WITHDRAWAL PLAN Our systematic withdrawal plan allows you to sell your shares and receive regular payments from your account on a monthly, quarterly, semiannual or annual basis. The value of your account must be at least $5,000 and the minimum payment amount for each withdrawal must be at least $50. There are no service charges for establishing or maintaining a systematic withdrawal plan. Once your plan is established, any distributions paid by the fund will be automatically reinvested in your account. Payments under the plan will be made from the redemption of an equivalent amount of shares in your account, generally on the 25th day of the month in which a payment is scheduled. If the 25th falls on a weekend or holiday, we will process the redemption on the next business day. When you sell your shares under a systematic withdrawal plan, it is a taxable transaction. To avoid paying sales charges on money you plan to withdraw within a short period of time, you may not want to set up a systematic withdrawal plan if you plan to buy shares on a regular basis. Shares sold under the plan also may be subject to a CDSC. Redeeming shares through a systematic withdrawal plan may reduce or exhaust the shares in your account if payments exceed distributions received from the fund. This is especially likely to occur if there is a market decline. If a withdrawal amount exceeds the value of your account, your account will be closed and the remaining balance in your account will be sent to you. Because the amount withdrawn under the plan may be more than your actual yield or income, part of the payment may be a return of your investment. You may discontinue a systematic withdrawal plan, change the amount and schedule of withdrawal payments, or suspend one payment by notifying us by mail or by phone at least seven business days before the end of the month preceding a scheduled payment. The fund may discontinue a systematic withdrawal plan by notifying you in writing and will automatically discontinue a systematic withdrawal plan if all shares in your account are withdrawn or if the fund receives notification of the shareholder's death or incapacity. REDEMPTIONS IN KIND Each fund has committed itself to pay in cash (by check) all requests for redemption by any shareholder of record, limited in amount, however, during any 90-day period to the lesser of $250,000 or 1% of the value of the fund's net assets at the beginning of the 90-day period. This commitment is irrevocable without the prior approval of the U.S. Securities and Exchange Commission (SEC). In the case of redemption requests in excess of these amounts, the board reserves the right to make payments in whole or in part in securities or other assets of the fund, in case of an emergency, or if the payment of such a redemption in cash would be detrimental to the existing shareholders of the fund. In these circumstances, the securities distributed would be valued at the price used to compute the fund's net assets and you may incur brokerage fees in converting the securities to cash. Redemptions in kind are taxable transactions. The fund does not intend to redeem illiquid securities in kind. If this happens, however, you may not be able to recover your investment in a timely manner. SHARE CERTIFICATES We will credit your shares to your fund account. We do not issue share certificates unless you specifically request them. This eliminates the costly problem of replacing lost, stolen or destroyed certificates. If a certificate is lost, stolen or destroyed, you may have to pay an insurance premium of up to 2% of the value of the certificate to replace it. Any outstanding share certificates must be returned to the fund if you want to sell or exchange those shares or if you would like to start a systematic withdrawal plan. The certificates should be properly endorsed. You can do this either by signing the back of the certificate or by completing a share assignment form. For your protection, you may prefer to complete a share assignment form and to send the certificate and assignment form in separate envelopes. GENERAL INFORMATION If dividend checks are returned to the fund marked "unable to forward" by the postal service, we will consider this a request by you to change your dividend option to reinvest all distributions. The proceeds will be reinvested in additional shares at net asset value until we receive new instructions. Distribution or redemption checks sent to you do not earn interest or any other income during the time the checks remain uncashed. Neither the funds nor their affiliates will be liable for any loss caused by your failure to cash such checks. The funds are not responsible for tracking down uncashed checks, unless a check is returned as undeliverable. In most cases, if mail is returned as undeliverable we are required to take certain steps to try to find you free of charge. If these attempts are unsuccessful, however, we may deduct the costs of any additional efforts to find you from your account. These costs may include a percentage of the account when a search company charges a percentage fee in exchange for its location services. The wiring of redemption proceeds is a special service that we make available whenever possible. By offering this service to you, the funds are not bound to meet any redemption request in less than the seven day period prescribed by law. Neither the funds nor their agents shall be liable to you or any other person if, for any reason, a redemption request by wire is not processed as described in the prospectus. Franklin Templeton Investor Services, Inc. (Investor Services) may pay certain financial institutions that maintain omnibus accounts with the funds on behalf of numerous beneficial owners for recordkeeping operations performed with respect to such owners. For each beneficial owner in the omnibus account, the fund may reimburse Investor Services an amount not to exceed the per account fee that the fund normally pays Investor Services. These financial institutions also may charge a fee for their services directly to their clients. If you buy or sell shares through your securities dealer, we use the net asset value next calculated after your securities dealer receives your request, which is promptly transmitted to the fund. If you sell shares through your securities dealer, it is your dealer's responsibility to transmit the order to the fund in a timely fashion. Your redemption proceeds will not earn interest between the time we receive the order from your dealer and the time we receive any required documents. Any loss to you resulting from your dealer's failure to transmit your redemption order to the fund in a timely fashion must be settled between you and your securities dealer. Certain shareholder servicing agents may be authorized to accept your transaction request. For institutional accounts, there may be additional methods of buying or selling fund shares than those described in this SAI or in the prospectus. In the event of disputes involving multiple claims of ownership or authority to control your account, the fund has the right (but has no obligation) to: (a) freeze the account and require the written agreement of all persons deemed by the fund to have a potential property interest in the account, before executing instructions regarding the account; (b) interplead disputed funds or accounts with a court of competent jurisdiction; or (c) surrender ownership of all or a portion of the account to the IRS in response to a notice of levy. PRICING SHARES - ------------------------------------------------------------------------------ When you buy shares, you pay the offering price. The offering price is the net asset value (NAV) per share plus any applicable sales charge, calculated to two decimal places using standard rounding criteria. When you sell shares, you receive the NAV minus any applicable CDSC. The value of a mutual fund is determined by deducting the fund's liabilities from the total assets of the portfolio. The net asset value per share is determined by dividing the net asset value of the fund by the number of shares outstanding. Each fund calculates the NAV per share of each class each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). The funds do not calculate the NAV on days the New York Stock Exchange (NYSE) is closed for trading, which include New Year's Day, Martin Luther King Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. When determining its NAV, each fund values cash and receivables at their realizable amounts, and records interest as accrued. Each fund values over-the-counter portfolio securities within the range of the most recent quoted bid and ask prices. If portfolio securities trade both in the over-the-counter market and on a stock exchange, each fund values them according to the broadest and most representative market as determined by the manager. Municipal securities generally trade in the over-the-counter market rather than on a securities exchange. In the absence of a sale or reported bid and ask prices, information with respect to bond and note transactions, quotations from bond dealers, market transactions in comparable securities, and various relationships between securities are used to determine the value of municipal securities. Generally, trading in U.S. government securities and money market instruments is substantially completed each day at various times before the close of the NYSE. The value of these securities used in computing the NAV is determined as of such times. Occasionally, events affecting the values of these securities may occur between the times at which they are determined and the close of the NYSE that will not be reflected in the computation of the NAV. If events materially affecting the values of these securities occur during this period, the securities will be valued at their fair value as determined in good faith by the board. Other securities for which market quotations are readily available are valued at the current market price, which may be obtained from a pricing service, based on a variety of factors including recent trades, institutional size trading in similar types of securities (considering yield, risk and maturity) and/or developments related to specific issues. Securities and other assets for which market prices are not readily available are valued at fair value as determined following procedures approved by the board. With the approval of the board, each fund may use a pricing service, bank or securities dealer to perform any of the above described functions. THE UNDERWRITER - ------------------------------------------------------------------------------ Franklin Templeton Distributors, Inc. (Distributors) acts as the principal underwriter in the continuous public offering of each fund's shares. Distributors is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Distributors pays the expenses of the distribution of fund shares, including advertising expenses and the costs of printing sales material and prospectuses used to offer shares to the public. Each fund pays the expenses of preparing and printing amendments to its registration statements and prospectuses (other than those necessitated by the activities of Distributors) and of sending prospectuses to existing shareholders. The table below shows the aggregate underwriting commissions Distributors received in connection with the offering of the funds' shares, the net underwriting discounts and commissions Distributors retained after allowances to dealers, and the amounts Distributors received in connection with redemptions or repurchases of shares for the last three fiscal years ended February 28: AMOUNT RECEIVED IN CONNECTION WITH TOTAL AMOUNT REDEMPTIONS COMMISSIONS RETAINED BY AND RECEIVED DISTRIBUTORS REPURCHASES ($) ($) ($) - --------------------------------------------------------------------------- 1999 Alabama Fund 1,184,364 76,087 3,487 Florida Fund 5,317,330 337,465 35,807 Georgia Fund 760,914 42,248 11,492 Kentucky Fund 343,647 22,834 - Louisiana Fund 716,996 46,235 3,048 Maryland Fund 1,309,307 82,392 10,749 Missouri Fund 1,996,212 120,370 5,859 North Carolina Fund 1,781,352 100,011 14,317 Texas Fund 282,886 17,460 1,125 Virginia Fund 1,754,574 110,385 10,724 1998 Alabama Fund 893,841 55,956 3,262 Florida Fund 6,501,473 424,153 7,601 Georgia Fund 705,553 42,875 1,464 Kentucky Fund 354,892 24,682 - Louisiana Fund 568,856 37,815 1,321 Maryland Fund 1,009,222 62,026 3,096 Missouri Fund 1,652,316 103,117 3,562 North Carolina Fund 1,557,597 95,165 6,473 Texas Fund 310,914 20,220 1,447 Virginia Fund 1,501,600 93,973 3,561 1997 Alabama Fund 714,659 46,026 859 Florida Fund 4,989,349 320,319 13,709 Georgia Fund 589,639 36,558 688 Kentucky Fund 263,208 16,972 - Louisiana Fund 503,212 30,444 5,331 Maryland Fund 925,907 55,499 2,211 Missouri Fund 1,133,635 71,462 2,759 North Carolina Fund 1,199,579 73,060 1,322 Texas Fund 254,844 16,652 16 Virginia Fund 1,202,582 76,437 1,039 Distributors may be entitled to reimbursement under the Rule 12b-1 plans, as discussed below. Except as noted, Distributors received no other compensation from the fund for acting as underwriter. DISTRIBUTION AND SERVICE (12B-1) FEES Each class has a separate distribution or "Rule 12b-1" plan. Under each plan, the fund shall pay or may reimburse Distributors or others for the expenses of activities that are primarily intended to sell shares of the class. These expenses may include, among others, distribution or service fees paid to securities dealers or others who have executed a servicing agreement with the fund, Distributors or its affiliates; a prorated portion of Distributors' overhead expenses; and the expenses of printing prospectuses and reports used for sales purposes, and preparing and distributing sales literature and advertisements. The distribution and service (12b-1) fees charged to each class are based only on the fees attributable to that particular class. THE CLASS A PLAN. Payments by each fund under the Class A plan may not exceed 0.10% per year of Class A's average daily net assets, payable quarterly. All distribution expenses over this amount will be borne by those who have incurred them. In implementing the Class A plan, the board has determined that the annual fees payable under the plan will be equal to the sum of: (i) the amount obtained by multiplying 0.10% by the average daily net assets represented by the fund's Class A shares that were acquired by investors on or after May 1, 1994, the effective date of the plan (new assets), and (ii) the amount obtained by multiplying 0.05% by the average daily net assets represented by the fund's Class A shares that were acquired before May 1, 1994 (old assets). These fees will be paid to the current securities dealer of record on the account. In addition, until such time as the maximum payment of 0.10% is reached on a yearly basis, up to an additional 0.02% will be paid to Distributors under the plan. When the fund reaches $4 billion in assets, the amount to be paid to Distributors will be reduced from 0.02% to 0.01%. The payments made to Distributors will be used by Distributors to defray other marketing expenses that have been incurred in accordance with the plan, such as advertising. The fee is a Class A expense. This means that all Class A shareholders, regardless of when they purchased their shares, will bear Rule 12b-1 expenses at the same rate. The initial rate will be at least 0.07% (0.05% plus 0.02%) of the average daily net assets of Class A and, as Class A shares are sold on or after May 1, 1994, will increase over time. Thus, as the proportion of Class A shares purchased on or after May 1, 1994, increases in relation to outstanding Class A shares, the expenses attributable to payments under the plan also will increase (but will not exceed 0.10% of average daily net assets). While this is the currently anticipated calculation for fees payable under the Class A plan, the plan permits the board to allow the fund to pay a full 0.10% on all assets at any time. The approval of the board would be required to change the calculation of the payments to be made under the Class A plan. The Class A plan does not permit unreimbursed expenses incurred in a particular year to be carried over to or reimbursed in later years. THE CLASS C PLAN. Under the Class C plans, the fund pays Distributors up to 0.50% per year of the class's average daily net assets, payable quarterly, to pay Distributors or others for providing distribution and related services and bearing certain expenses. All distribution expenses over this amount will be borne by those who have incurred them. The fund also may pay a servicing fee of up to 0.15% per year of the class's average daily net assets, payable quarterly. This fee may be used to pay securities dealers or others for, among other things, helping to establish and maintain customer accounts and records, helping with requests to buy and sell shares, receiving and answering correspondence, monitoring dividend payments from the fund on behalf of customers, and similar servicing and account maintenance activities. The expenses relating to the Class C plan also are used to pay Distributors for advancing the commission costs to securities dealers with respect to the initial sale of Class C shares. THE CLASS A AND C PLANS. In addition to the payments that Distributors or others are entitled to under each plan, each plan also provides that to the extent the fund, the manager or Distributors or other parties on behalf of the fund, the manager or Distributors make payments that are deemed to be for the financing of any activity primarily intended to result in the sale of fund shares within the context of Rule 12b-1 under the Investment Company Act of 1940, as amended, then such payments shall be deemed to have been made pursuant to the plan. The terms and provisions of each plan relating to required reports, term, and approval are consistent with Rule 12b-1. In no event shall the aggregate asset-based sales charges, which include payments made under each plan, plus any other payments deemed to be made pursuant to a plan, exceed the amount permitted to be paid under the rules of the National Association of Securities Dealers, Inc. To the extent fees are for distribution or marketing functions, as distinguished from administrative servicing or agency transactions, certain banks will not be entitled to participate in the plans as a result of applicable federal law prohibiting certain banks from engaging in the distribution of mutual fund shares. These banking institutions, however, are permitted to receive fees under the plans for administrative servicing or for agency transactions. If you are a customer of a bank that is prohibited from providing these services, you would be permitted to remain a shareholder of the fund, and alternate means for continuing the servicing would be sought. In this event, changes in the services provided might occur and you might no longer be able to avail yourself of any automatic investment or other services then being provided by the bank. It is not expected that you would suffer any adverse financial consequences as a result of any of these changes. Each plan has been approved in accordance with the provisions of Rule 12b-1. The plans are renewable annually by a vote of the board, including a majority vote of the board members who are not interested persons of the fund and who have no direct or indirect financial interest in the operation of the plans, cast in person at a meeting called for that purpose. It is also required that the selection and nomination of such board members be done by the noninterested members of the fund's board. The plans and any related agreement may be terminated at any time, without penalty, by vote of a majority of the noninterested board members on not more than 60 days' written notice, by Distributors on not more than 60 days' written notice, by any act that constitutes an assignment of the management agreement with the manager or by vote of a majority of the outstanding shares of the class. Distributors or any dealer or other firm also may terminate their respective distribution or service agreement at any time upon written notice. The plans and any related agreements may not be amended to increase materially the amount to be spent for distribution expenses without approval by a majority of the outstanding shares of the class, and all material amendments to the plans or any related agreements shall be approved by a vote of the noninterested board members, cast in person at a meeting called for the purpose of voting on any such amendment. Distributors is required to report in writing to the board at least quarterly on the amounts and purpose of any payment made under the plans and any related agreements, as well as to furnish the board with such other information as may reasonably be requested in order to enable the board to make an informed determination of whether the plans should be continued. For the fiscal year ended February 28, 1999, Distributors' eligible expenditures for advertising, printing, and payments to underwriters and broker-dealers pursuant to the plans and the amounts the funds paid Distributors under the plans were: DISTRIBUTORS' AMOUNT ELIGIBLE PAID BY THE EXPENSES ($) FUND ($) - ------------------------------------------------------------------------------ Alabama Fund - Class A 263,806 208,274 Alabama Fund - Class C 117,792 75,909 Florida Fund - Class A 1,923,363 1,556,429 Florida Fund - Class C 647,063 430,592 Georgia Fund - Class A 246,069 150,648 Georgia Fund - Class C 162,210 82,938 Kentucky Fund 124,230 59,051 Louisiana Fund - Class A 193,708 130,917 Louisiana Fund - Class C 94,882 46,261 Maryland Fund - Class A 314,716 223,888 Maryland Fund - Class C 151,286 88,149 Missouri Fund - Class A 427,164 312,809 Missouri Fund - Class C 175,293 93,317 North Carolina Fund - Class A 388,615 303,507 North Carolina Fund - Class C 332,645 183,005 Texas Fund - Class A 177,070 111,102 Texas Fund - Class C 48,823 21,057 Virginia Fund - Class A 409,989 326,787 Virginia Fund - Class C 180,589 109,653 PERFORMANCE - ------------------------------------------------------------------------------ Performance quotations are subject to SEC rules. These rules require the use of standardized performance quotations or, alternatively, that every non-standardized performance quotation furnished by the fund be accompanied by certain standardized performance information computed as required by the SEC. Average annual total return and current yield quotations used by the funds are based on the standardized methods of computing performance mandated by the SEC. Performance figures reflect Rule 12b-1 fees from the date of the plan's implementation. An explanation of these and other methods used by the fund to compute or express performance follows. Regardless of the method used, past performance does not guarantee future results, and is an indication of the return to shareholders only for the limited historical period used. AVERAGE ANNUAL TOTAL RETURN Average annual total return is determined by finding the average annual rates of return over the periods indicated below that would equate an initial hypothetical $1,000 investment to its ending redeemable value. The calculation assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. The quotation assumes the account was completely redeemed at the end of each period and the deduction of all applicable charges and fees. If a change is made to the sales charge structure, historical performance information will be restated to reflect the maximum initial sales charge currently in effect. When considering the average annual total return quotations, you should keep in mind that the maximum initial sales charge reflected in each quotation is a one time fee charged on all direct purchases, which will have its greatest impact during the early stages of your investment. This charge will affect actual performance less the longer you retain your investment in the fund. The average annual total returns for the indicated periods ended February 28, 1999, were: INCEPTION 1 5 10 SINCE DATE YEAR YEARS YEARS INCEPTION - ------------------------------------------------------------------------------- CLASS A Alabama Fund 09/01/87 -1.17% 4.87% 7.00% 7.28% Florida Fund 09/01/87 1.23% 5.26% 7.32% 7.67% Georgia Fund 09/01/87 0.73% 4.91% 7.13% 7.37% Kentucky Fund 10/12/91 1.01% 5.36% - 6.93% Louisiana Fund 09/01/87 0.71% 4.96% 7.16% 7.35% Maryland Fund 10/03/88 1.13% 5.28% 7.23% 7.07% Missouri Fund 09/01/87 0.67% 5.30% 7.43% 7.53% North Carolina Fund 09/01/87 1.03% 5.05% 7.10% 7.44% Texas Fund 09/01/87 0.39% 5.18% 7.22% 7.56% Virginia Fund 09/01/87 0.90% 5.07% 7.26% 7.49% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------ CLASS C Alabama Fund 0.64% 6.02% Florida Fund 3.18% 6.45% Georgia Fund 2.69% 6.05% Louisiana Fund 2.55% 6.42% Maryland Fund 3.06% 6.65% Missouri Fund 2.58% 6.62% North Carolina Fund 3.01% 6.45% Texas Fund 2.38% 6.62% Virginia Fund 2.75% 6.37% The following SEC formula was used to calculate these figures: n P(1+T) = ERV where: P = a hypothetical initial payment of $1,000 T = average annual total return n = number of years ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of each period at the end of each period CUMULATIVE TOTAL RETURN Like average annual total return, cumulative total return assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. Cumulative total return, however, is based on the actual return for a specified period rather than on the average return over the periods indicated above. The cumulative total returns for the indicated periods ended February 28, 1999, were: INCEPTION 1 5 10 SINCE DATE YEAR YEARS YEARS INCEPTION - ------------------------------------------------------------------------------ CLASS A Alabama Fund 09/01/87 -1.17% 26.87% 96.75% 124.27% Florida Fund 09/01/87 1.23% 29.19% 102.72% 133.89% Georgia Fund 09/01/87 0.73% 27.08% 99.05% 126.53% Kentucky Fund 10/12/91 1.01% 29.80% - 64.03% Louisiana Fund 09/01/87 0.71% 27.41% 99.63% 125.85% Maryland Fund 10/03/88 1.13% 29.35% 100.93% 103.59% Missouri Fund 09/01/87 0.67% 29.44% 104.68% 130.29% North Carolina Fund 09/01/87 1.03% 27.93% 98.56% 128.26% Texas Fund 09/01/87 0.39% 28.72% 100.73% 131.17% Virginia Fund 09/01/87 0.90% 28.06% 101.49% 129.29% SINCE INCEPTION 1 YEAR (5/1/95) - ------------------------------------------------------------------------------ CLASS C Alabama Fund 0.64% 25.09% Florida Fund 3.18% 27.03% Georgia Fund 2.69% 25.22% Louisiana Fund 2.55% 26.92% Maryland Fund 3.06% 27.95% Missouri Fund 2.58% 27.84% North Carolina Fund 3.01% 27.07% Texas Fund 2.38% 27.83% Virginia Fund 2.75% 26.66% CURRENT YIELD Current yield shows the income per share earned by a fund. It is calculated by dividing the net investment income per share earned during a 30-day base period by the applicable maximum offering price per share on the last day of the period and annualizing the result. Expenses accrued for the period include any fees charged to all shareholders of the class during the base period. The yields for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ------------------------------------------------------------------------------ Alabama Fund 4.14% 3.72% Florida Fund 3.78% 3.35% Georgia Fund 3.85% 3.43% Kentucky Fund 3.99% - Louisiana Fund 4.11% 3.69% Maryland Fund 3.86% 3.45% Missouri Fund 3.95% 3.53% North Carolina Fund 3.83% 3.41% Texas Fund 3.94% 3.52% Virginia Fund 3.95% 3.53% The following SEC formula was used to calculate these figures: 6 Yield = 2 [(a-b + 1) - 1] --- cd where: a = interest earned during the period b = expenses accrued for the period (net of reimbursements) c = the average daily number of shares outstanding during the period that were entitled to receive dividends d = the maximum offering price per share on the last day of the period TAXABLE-EQUIVALENT YIELD Each fund also may quote a taxable-equivalent yield that shows the before-tax yield that would have to be earned from a taxable investment to equal the yield. Taxable-equivalent yield is computed by dividing the portion of the yield that is tax-exempt by one minus the highest applicable combined federal and state income tax rate and adding the product to the portion of the yield that is not tax-exempt, if any. The taxable-equivalent yields for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ------------------------------------------------------------------------------ Alabama Fund 7.22% 6.48% Florida Fund 6.26% 5.55% Georgia Fund 6.78% 6.04% Kentucky Fund 7.03% - Louisiana Fund 7.24% 6.50% Maryland Fund 6.93% 6.19% Missouri Fund 6.96% 6.22% North Carolina Fund 6.87% 6.12% Texas Fund 6.52% 5.83% Virginia Fund 6.94% 6.20% As of February 28, 1999, the combined federal and state income tax rate upon which the taxable-equivalent yield quotations are based were as follows: COMBINED RATE - ------------------------------------------------------------------------------ Alabama Fund 42.6% Florida Fund 39.6% Georgia Fund 43.2% Kentucky Fund 43.2% Louisiana Fund 43.2% Maryland Fund 44.3% Missouri Fund 43.2% North Carolina Fund 44.3% Texas Fund 39.6% Virginia Fund 43.1% From time to time, as any changes to the rate become effective, taxable-equivalent yield quotations advertised by the funds will be updated to reflect these changes. The funds expect updates may be necessary as tax rates are changed by federal and state governments. The advantage of tax-free investments, like the funds, will be enhanced by any tax rate increases. Therefore, the details of specific tax increases may be used in sales material for the funds. CURRENT DISTRIBUTION RATE Current yield and taxable-equivalent yield, which are calculated according to a formula prescribed by the SEC, are not indicative of the amounts which were or will be paid to shareholders. Amounts paid to shareholders are reflected in the quoted current distribution rate or taxable-equivalent distribution rate. The current distribution rate is usually computed by annualizing the dividends paid per share by a class during a certain period and dividing that amount by the current maximum offering price. The current distribution rate differs from the current yield computation because it may include distributions to shareholders from sources other than interest, if any, and is calculated over a different period of time. The current distribution rates for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ------------------------------------------------------------------------------ Alabama Fund 4.92% 4.47% Florida Fund 4.82% 4.38% Georgia Fund 4.71% 4.33% Kentucky Fund 4.86% - Louisiana Fund 4.86% 4.41% Maryland Fund 4.53% 4.08% Missouri Fund 4.71% 4.29% North Carolina Fund 4.68% 4.23% Texas Fund 4.88% 4.39% Virginia Fund 4.69% 4.27% A taxable-equivalent distribution rate shows the taxable distribution rate equivalent to the current distribution rate. The advertised taxable-equivalent distribution rate will reflect the most current federal and state tax rates available to the fund. The taxable-equivalent distribution rates for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ------------------------------------------------------------------------------ Alabama Fund 8.57% 7.79% Florida Fund 7.98% 7.25% Georgia Fund 8.30% 7.63% Kentucky Fund 8.56% - Louisiana Fund 8.56% 7.77% Maryland Fund 8.13% 7.32% Missouri Fund 8.30% 7.56% North Carolina Fund 8.40% 7.59% Texas Fund 8.08% 7.27% Virginia Fund 8.24% 7.50% VOLATILITY Occasionally statistics may be used to show a fund's volatility or risk. Measures of volatility or risk are generally used to compare a fund's net asset value or performance to a market index. One measure of volatility is beta. Beta is the volatility of a fund relative to the total market, as represented by an index considered representative of the types of securities in which the fund invests. A beta of more than 1.00 indicates volatility greater than the market and a beta of less than 1.00 indicates volatility less than the market. Another measure of volatility or risk is standard deviation. Standard deviation is used to measure variability of net asset value or total return around an average over a specified period of time. The idea is that greater volatility means greater risk undertaken in achieving performance. OTHER PERFORMANCE QUOTATIONS The funds also may quote the performance of shares without a sales charge. Sales literature and advertising may quote a cumulative total return, average annual total return and other measures of performance with the substitution of net asset value for the public offering price. Each fund may include in its advertising or sales material information relating to investment goals and performance results of funds belonging to the Franklin Templeton Group of Funds. Franklin Resources, Inc. is the parent company of the advisors and underwriter of the Franklin Templeton Group of Funds. COMPARISONS To help you better evaluate how an investment in the fund may satisfy your investment goal, advertisements and other materials about the fund may discuss certain measures of fund performance as reported by various financial publications. Materials also may compare performance (as calculated above) to performance as reported by other investments, indices and averages. These comparisons may include, but are not limited to, the following examples: o Salomon Brothers Broad Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate and mortgage bonds. o Lehman Brothers Aggregate Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate, mortgage and Yankee bonds. o Lehman Brothers Municipal Bond Index or its component indices - measures yield, price and total return for the municipal bond market. o Bond Buyer 20 Index - an index of municipal bond yields based upon yields of 20 general obligation bonds maturing in 20 years. o Bond Buyer 40 Index - an index composed of the yield to maturity of 40 bonds. The index attempts to track the new-issue market as closely as possible, so it changes bonds twice a month, adding all new bonds that meet certain requirements and deleting an equivalent number according to their secondary market trading activity. As a result, the average par call date, average maturity date, and average coupon rate can and have changed over time. The average maturity generally has been about 29-30 years. o Financial publications: The Wall Street Journal, and Business Week, Financial World, Forbes, Fortune, and Money magazines - provide performance statistics over specified time periods. o Salomon Brothers Composite High Yield Index or its component indices - measures yield, price and total return for the Long-Term High-Yield Index, Intermediate-Term High-Yield Index, and Long-Term Utility High-Yield Index. o Historical data supplied by the research departments of CS First Boston Corporation, the J. P. Morgan companies, Salomon Brothers, Merrill Lynch, Lehman Brothers and Bloomberg L.P. o Morningstar - information published by Morningstar, Inc., including Morningstar proprietary mutual fund ratings. The ratings reflect Morningstar's assessment of the historical risk-adjusted performance of a fund over specified time periods relative to other funds within its category. o Lipper - Mutual Fund Performance Analysis and Lipper - Fixed Income Fund Performance Analysis - measure total return and average current yield for the mutual fund industry and rank individual mutual fund performance over specified time periods, assuming reinvestment of all distributions, exclusive of any applicable sales charges. o Savings and Loan Historical Interest Rates - as published in the U.S. Savings & Loan League Fact Book. o Consumer Price Index (or Cost of Living Index), published by the U.S. Bureau of Labor Statistics - a statistical measure of change, over time, in the price of goods and services in major expenditure groups. o CDA Mutual Fund Report, published by CDA Investment Technologies, Inc. - analyzes price, current yield, risk, total return, and average rate of return (average annual compounded growth rate) over specified time periods for the mutual fund industry. o Standard & Poor's Bond Indices - measure yield and price of corporate, municipal, and government bonds. From time to time, advertisements or information for each fund may include a discussion of certain attributes or benefits to be derived from an investment in the fund. The advertisements or information may include symbols, headlines, or other material that highlights or summarizes the information discussed in more detail in the communication. Advertisements or sales material issued by each fund also may discuss or be based upon information in a recent issue of the Special Report on Tax Freedom Day published by the Tax Foundation, a Washington, D.C. based nonprofit research and public education organization. The report illustrates, among other things, the annual amount of time the average taxpayer works to satisfy his or her tax obligations to the federal, state and local taxing authorities. Advertisements or information also may compare each fund's performance to the return on certificates of deposit (CDs) or other investments. You should be aware, however, that an investment in the fund involves the risk of fluctuation of principal value, a risk generally not present in an investment in a CD issued by a bank. For example, as the general level of interest rates rise, the value of the fund's fixed-income investments, as well as the value of its shares that are based upon the value of such portfolio investments, can be expected to decrease. Conversely, when interest rates decrease, the value of the fund's shares can be expected to increase. CDs are frequently insured by an agency of the U.S. government. An investment in a fund is not insured by any federal, state or private entity. In assessing comparisons of performance, you should keep in mind that the composition of the investments in the reported indices and averages is not identical to any fund's portfolio, the indices and averages are generally unmanaged, and the items included in the calculations of the averages may not be identical to the formula used by a fund to calculate its figures. In addition, there can be no assurance that a fund will continue its performance as compared to these other averages. MISCELLANEOUS INFORMATION - ------------------------------------------------------------------------------ The funds may help you achieve various investment goals such as accumulating money for retirement, saving for a down payment on a home, college costs and other long-term goals. The Franklin College Costs Planner may help you in determining how much money must be invested on a monthly basis in order to have a projected amount available in the future to fund a child's college education. (Projected college cost estimates are based upon current costs published by the College Board.) The Franklin Retirement Planning Guide leads you through the steps to start a retirement savings program. Of course, an investment in the funds cannot guarantee that these goals will be met. The funds are members of the Franklin Templeton Group of Funds, one of the largest mutual fund organizations in the U.S., and may be considered in a program for diversification of assets. Founded in 1947, Franklin is one of the oldest mutual fund organizations and now services more than 4 million shareholder accounts. In 1992, Franklin, a leader in managing fixed-income mutual funds and an innovator in creating domestic equity funds, joined forces with Templeton, a pioneer in international investing. The Mutual Series team, known for its value-driven approach to domestic equity investing, became part of the organization four years later. Together, the Franklin Templeton Group has over $227 billion in assets under management for more than 7 million U.S. based mutual fund shareholder and other accounts. The Franklin Templeton Group of Funds offers 113 U.S. based open-end investment companies to the public. Each fund may identify itself by its NASDAQ symbol or CUSIP number. Franklin is a leader in the tax-free mutual fund industry and manages more than $51 billion in municipal security assets for over three quarters of a million investors. According to Research and Ratings Review, Franklin had one of the largest staffs of municipal securities analysts in the industry, as of June 30, 1998. Under current tax laws, municipal securities remain one of the few investments offering the potential for tax-free income. In 1999, taxes could cost almost $47 on every $100 earned from a fully taxable investment (based on the maximum combined 39.6% federal tax rate and the highest state tax rate of 12% for 1999). Franklin tax-free funds, however, offer tax relief through a professionally managed portfolio of tax-free securities selected based on their yield, quality and maturity. An investment in a Franklin tax-free fund can provide you with the potential to earn income free of federal taxes and, depending on the fund, state and local taxes as well, while supporting state and local public projects. Franklin tax-free funds also may provide tax-free compounding, when dividends are reinvested. An investment in Franklin's tax-free funds can grow more rapidly than similar taxable investments. Municipal securities are generally considered to be creditworthy, second in quality only to securities issued or guaranteed by the U.S. government and its agencies. The market price of municipal securities, however, may fluctuate. This fluctuation will have a direct impact on the net asset value of the fund's shares. Currently, there are more mutual funds than there are stocks listed on the New York Stock Exchange. While many of them have similar investment goals, no two are exactly alike. Shares of the fund are generally sold through securities dealers, whose investment representatives are experienced professionals who can offer advice on the type of investments suitable to your unique goals and needs, as well as the risks associated with such investments. The Information Services & Technology division of Franklin Resources, Inc. (Resources) established a Year 2000 Project Team in 1996. This team has already begun making necessary software changes to help the computer systems that service the fund and its shareholders to be Year 2000 compliant. After completing these modifications, comprehensive tests are conducted in one of Resources' U.S. test labs to verify their effectiveness. Resources continues to seek reasonable assurances from all major hardware, software or data-services suppliers that they will be Year 2000 compliant on a timely basis. Resources is also beginning to develop a contingency plan, including identification of those mission critical systems for which it is practical to develop a contingency plan. However, in an operation as complex and geographically distributed as Resources' business, the alternatives to use of normal systems, especially mission critical systems, or supplies of electricity or long distance voice and data lines are limited. DESCRIPTION OF RATINGS - ------------------------------------------------------------------------------ MUNICIPAL BOND RATINGS MOODY'S INVESTORS SERVICE, INC. (MOODY'S) Aaa: Municipal bonds rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt-edged." Interest payments are protected by a large or exceptionally stable margin, and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa: Municipal bonds rated Aa are judged to be high quality by all standards. Together with the Aaa group, they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large, fluctuation of protective elements may be of greater amplitude, or there may be other elements present that make the long-term risks appear somewhat larger. A: Municipal bonds rated A possess many favorable investment attributes and are considered upper medium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present that suggest a susceptibility to impairment sometime in the future. Baa: Municipal bonds rated Baa are considered medium-grade obligations. They are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. These bonds lack outstanding investment characteristics and, in fact, have speculative characteristics as well. Ba: Municipal bonds rated Ba are judged to have predominantly speculative elements and their future cannot be considered well assured. Often the protection of interest and principal payments may be very moderate and, thereby, not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B: Municipal bonds rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Caa: Municipal bonds rated Caa are of poor standing. These issues may be in default or there may be present elements of danger with respect to principal or interest. Ca: Municipal bonds rated Ca represent obligations that are speculative to a high degree. These issues are often in default or have other marked shortcomings. C: Municipal bonds rated C are the lowest-rated class of bonds and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. Con.(-): Municipal bonds for which the security depends upon the completion of some act or the fulfillment of some condition are rated conditionally. These are bonds secured by (a) earnings of projects under construction, (b) earnings of projects unseasoned in operation experience, (c) rentals that begin when facilities are completed, or (d) payments to which some other limiting condition attaches. Parenthetical rating denotes probable credit stature upon the completion of construction or the elimination of the basis of the condition. STANDARD & POOR'S CORPORATION (S&P) AAA: Municipal bonds rated AAA are the highest-grade obligations. They possess the ultimate degree of protection as to principal and interest. In the market, they move with interest rates and, hence, provide the maximum safety on all counts. AA: Municipal bonds rated AA also qualify as high-grade obligations, and in the majority of instances differ from AAA issues only in a small degree. Here, too, prices move with the long-term money market. A: Municipal bonds rated A are regarded as upper medium-grade. They have considerable investment strength but are not entirely free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They predominantly reflect money rates in their market behavior but also, to some extent, economic conditions. BBB: Municipal bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas they normally exhibit adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds in this category than for bonds in the A category. BB, B, CCC, CC: Municipal bonds rated BB, B, CCC and CC are regarded, on balance, as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal in accordance with the terms of the obligations. BB indicates the lowest degree of speculation and CC the highest degree of speculation. While these bonds will likely have some quality and protective characteristics, they are outweighed by large uncertainties or major risk exposures to adverse conditions. C: This rating is reserved for income bonds on which no interest is being paid. D: Debt rated "D" is in default and payment of interest and/or repayment of principal is in arrears. Plus (+) or minus (-): The ratings from "AA" to "CCC" may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. FITCH INVESTORS SERVICE, INC. (FITCH) AAA: Municipal bonds rated AAA are considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal that is unlikely to be affected by reasonably foreseeable events. AA: Municipal bonds rated AA are considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong although not quite as strong as bonds rated AAA and not significantly vulnerable to foreseeable future developments. A: Municipal bonds rated A are considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB: Municipal bonds rated BBB are considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have an adverse impact on these bonds, and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB: Municipal bonds rated BB are considered speculative. The obligor's ability to pay interest and repay principal may be affected over time by adverse economic changes. Business and financial alternatives can be identified, however, that could assist the obligor in satisfying its debt service requirements. B: Municipal bonds rated B are considered highly speculative. While bonds in this class are currently meeting debt service requirements, the probability of continued timely payment of principal and interest reflects the obligor's limited margin of safety and the need for reasonable business and economic activity throughout the life of the issue. CCC: Municipal bonds rated CCC have certain identifiable characteristics which, if not remedied, may lead to default. The ability to meet obligations requires an advantageous business and economic environment. CC: Municipal bonds rated CC are minimally protected. Default in payment of interest and/or principal seems probable over time. C: Municipal bonds rated C are in imminent default in the payment of interest or principal. DDD, DD and D: Municipal bonds rated DDD, DD and D are in default on interest and/or principal payments. Such bonds are extremely speculative and should be valued on the basis of their ultimate recovery value in liquidation or reorganization of the obligor. DDD represents the highest potential for recovery while D represents the lowest potential for recovery. Plus (+) or minus (-) signs are used with a rating symbol to indicate the relative position of a credit within the rating category. Plus or minus signs are not used with the AAA, DDD, DD or D categories. MUNICIPAL NOTE RATINGS MOODY'S Moody's ratings for state, municipal and other short-term obligations will be designated Moody's Investment Grade (MIG). This distinction is in recognition of the differences between short-term credit risk and long-term risk. Factors affecting the liquidity of the borrower are uppermost in importance in short-term borrowing; factors of the first importance in long-term borrowing risk are of lesser importance in the short run. Symbols used will be as follows: MIG 1: Notes are of the best quality enjoying strong protection from established cash flows of funds for their servicing or from established and broad-based access to the market for refinancing, or both. MIG 2: Notes are of high quality, with margins of protection ample, although not so large as in the preceding group. MIG 3: Notes are of favorable quality, with all security elements accounted for, but lacking the undeniable strength of the preceding grades. Market access for refinancing, in particular, is likely to be less well established. MIG 4: Notes are of adequate quality, carrying specific risk but having protection and not distinctly or predominantly speculative. S&P Until June 29, 1984, S&P used the same rating symbols for notes and bonds. After June 29, 1984, for new municipal note issues due in three years or less, the ratings below will usually be assigned. Notes maturing beyond three years will most likely receive a bond rating of the type recited above. SP-1: Issues carrying this designation have a very strong or strong capacity to pay principal and interest. Issues determined to possess overwhelming safety characteristics will be given a "plus" (+) designation. SP-2: Issues carrying this designation have a satisfactory capacity to pay principal and interest. SHORT-TERM DEBT & COMMERCIAL PAPER RATINGS MOODY'S Moody's short-term debt ratings are opinions of the ability of issuers to repay punctually senior debt obligations. These obligations have an original maturity not exceeding one year, unless explicitly noted. Moody's commercial paper ratings, which are also applicable to municipal paper investments, are opinions of the ability of issuers to repay punctually their promissory obligations not having an original maturity in excess of nine months. Moody's employs the following designations for both short-term debt and commercial paper, all judged to be investment grade, to indicate the relative repayment capacity of rated issuers: P-1 (Prime-1): Superior capacity for repayment. P-2 (Prime-2): Strong capacity for repayment. S&P S&P's ratings are a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Ratings are graded into four categories, ranging from "A" for the highest quality obligations to "D" for the lowest. Issues within the "A" category are delineated with the numbers 1, 2 and 3 to indicate the relative degree of safety, as follows: A-1: This designation indicates the degree of safety regarding timely payment is very strong. A "plus" (+) designation indicates an even stronger likelihood of timely payment. A-2: Capacity for timely payment on issues with this designation is strong. The relative degree of safety, however, is not as overwhelming as for issues designated A-1. A-3: Issues carrying this designation have a satisfactory capacity for timely payment. They are, however, somewhat more vulnerable to the adverse effects of changes in circumstances than obligations carrying the higher designations. FITCH Fitch's short-term ratings apply to debt obligations that are payable on demand or have original maturities of generally up to three years, including commercial paper, certificates of deposit, medium-term notes, and municipal and investment notes. The short-term rating places greater emphasis than a long-term rating on the existence of liquidity necessary to meet the issuer's obligations in a timely manner. F-1+: Exceptionally strong credit quality. Regarded as having the strongest degree of assurance for timely payment. F-1: Very strong credit quality. Reflect an assurance of timely payment only slightly less in degree than issues rated F-1+. F-2: Good credit quality. A satisfactory degree of assurance for timely payment, but the margin of safety is not as great as for issues assigned F-1+ and F-1 ratings. F-3: Fair credit quality. Have characteristics suggesting that the degree of assurance for timely payment is adequate; however, near-term adverse changes could cause these securities to be rated below investment grade. F-5: Weak credit quality. Have characteristics suggesting a minimal degree of assurance for timely payment and are vulnerable to near-term adverse changes in financial and economic conditions. D: Default. Actual or imminent payment default. LOC: The symbol LOC indicates that the rating is based on a letter of credit issued by a commercial bank. STATE TAX TREATMENT - ------------------------------------------------------------------------------ The following information on the state income tax treatment of dividends from a fund is based upon correspondence and sources believed to be reliable. Except where otherwise noted, the information pertains to individual state income taxation only. You may be subject to local taxes on dividends or the value of your shares. Corporations, trusts, estates and other entities may be subject to other taxes and should consult with their tax advisors or their state department of revenue. For some investors, a portion of the dividend income may be subject to the federal and/or state alternative minimum tax. ALABAMA Under Section 40-18-14(3)f of the Alabama Code, interest on obligations of the state of Alabama and any of its counties, municipalities or other political subdivisions is exempt from personal income tax. Section 40-18-14(3)d provides similar tax-exempt treatment for interest on exempt obligations of the U.S. government or its possessions including Puerto Rico, Guam and the Virgin Islands. In addition, Regulation Section 810-3-14-.02(4)(b)2 and an administrative ruling of the Alabama Department of Revenue, dated March 1, 1990, both extend the exemption for obligations of the U.S. government or its possessions to distributions from a regulated investment company, such as the Alabama Fund, to the extent that the distributions are paid from interest earned on such exempt obligations. The March 1, 1990, ruling (as well as the instructions to Alabama Form 40) also indicates that the exemption would apply to Alabama municipal obligations. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations or obligations of other states and their political subdivisions. To the extent such investments are made by the fund, distributions from those investments generally will be taxable. Any distributions of capital gains earned by the fund are fully includable in each individual shareholder's Alabama taxable income and are currently taxed at ordinary income tax rates. FLORIDA does not have a personal income tax but does have an intangible personal property tax for residents. According to Florida Statute Section 199.185 and Technical Assistance Advisement 90(C)2-003, issued by the Florida Department of Revenue on August 8, 1990 (as later revised), shares in regulated investment companies organized as business trusts, such as the Florida Fund, will not be subject to Florida's intangible property tax to the extent that the fund is invested in exempt obligations of the U.S. government, its agencies, instrumentalities and territories (including Puerto Rico, Guam and the Virgin Islands) at the close of business on the last business day of the previous calendar year. If the fund invests all of the remaining portion of its net asset value in exempt obligations of the state of Florida or its municipalities or political subdivisions on such date, then that remaining portion of the net asset value of the fund (and corresponding value of fund shares) will also be exempt from Florida's intangibles tax. According to Florida Technical Assistance Advisement 94(c)2-025, if the fund invests, such as for temporary or defensive purposes, any of the remaining portion of its portfolio in any asset that is taxable under Florida's intangible tax law, including investments in indirect federal obligations (GNMAs, FNMAs, etc.) or obligations of any other states, then only the portion of net asset value, if any, that is made up of direct obligations of the U.S. government, or territories and possessions of the U.S. government, may be excluded from tax. The remaining net asset value of the fund (and corresponding value of fund shares) is then subject to tax. GEORGIA Under Section 48-7-27(b)(1)(A) of the Georgia Code, interest on obligations of the state of Georgia and its political subdivisions, which is not otherwise included in federal adjusted gross income, is exempt from the state's individual income tax. Likewise, under Section 48-7-27(b)(2) interest on exempt obligations of the U.S. government, its territories and possessions (including Puerto Rico, Guam and the Virgin Islands), or of any authority, commission, or instrumentality of the U.S. government also is exempt from the state's individual income tax. According to the instructions to Georgia's personal income tax return, distributions from the Georgia Fund attributable to interest on obligations of the state of Georgia and its political subdivisions and, apparently, to interest on obligations of the U.S. government, its territories and possessions will be excluded from the Georgia individual income tax. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by a fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of capital gains earned by the fund are fully included in each individual shareholder's Georgia taxable income as dividend income and capital gain, respectively, and are currently taxed at ordinary income tax rates. KENTUCKY Pursuant to Kentucky Revised Statute 141.010(10)(a) and (12)(a), interest earned on exempt obligations of the U.S. government, its agencies and instrumentalities, or its territories (including Puerto Rico, Guam and the Virgin Islands) and obligations issued by the Commonwealth of Kentucky or its political subdivisions will be exempt from Kentucky's personal income tax. Under Kentucky Income Tax Revenue Policy 42P161 (as revised December 1, 1990), dividends from regulated investment companies, such as the Kentucky Fund, which are derived from such exempt obligations, also will be exempt from state income tax. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund are includable in each shareholder's Kentucky adjusted gross income and are taxed at ordinary income tax rates. Kentucky Revenue Circular 40C003 also states that gain from the sale of some U.S. government and Kentucky obligations may be exempt from state income tax, but the availability of the exemption depends upon the specific legislation authorizing the bonds. A specific opinion may be requested from the Kentucky Revenue Cabinet. LOUISIANA Under Section 47:293 of Louisiana's individual income tax law, interest earned on exempt obligations of the state of Louisiana or its political subdivisions and interest earned on exempt obligations of the U.S. government or its agencies and possessions (including Puerto Rico, Guam and the Virgin Islands) is exempt from individual and corporate income tax. Under Section 47:293, distributions from a regulated investment company, such as the Louisiana Fund, also will be exempt from individual and corporate income tax to the extent that they are derived from interest earned on such exempt obligations. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund are included in each shareholder's Louisiana taxable income and are currently taxed at ordinary income tax rates. MARYLAND Distributions from the Maryland Fund attributable to interest on obligations of the state of Maryland and its political subdivisions are excluded from Maryland's personal income tax. Under Section 10-207(c) of the Tax General Article, interest on exempt obligations of the U.S. government and any authority, commission, instrumentality, possession or territory of the U.S. (including Puerto Rico, Guam and the Virgin Islands) also is exempt from Maryland's personal income tax. Under Section 10-207(c-1) and Administrative Release No. 11, this exemption is extended to distributions from a regulated investment company, such as the Maryland Fund, to the extent such distributions are paid out of interest earned on exempt obligations of the U.S. government or its agencies and possessions (including Puerto Rico, Guam and the U.S. Virgin Islands). Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of capital gains by the fund derived from gain realized from the sale or exchange of obligations issued by the state of Maryland or its political subdivisions also may be tax-exempt to the fund's shareholders. Distributions of capital gains earned by the fund on non-Maryland obligations are includable in each shareholder's Maryland adjusted gross income and are taxed at ordinary income tax rates. MISSOURI Under Section 143.121 of the Revised Statutes of Missouri, interest earned on exempt obligations of the U.S. government, its authorities, commissions, instrumentalities, possessions or territories (including Puerto Rico, Guam and the Virgin Islands), or the state of Missouri, its political subdivisions or authorities are exempt from Missouri personal income tax. Under Missouri's income tax regulations (Title 12, Section 10-2.155), a regulated investment company such as the Missouri Fund may pass the tax-exempt character of such interest through to its shareholders. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund are included in each shareholder's Missouri taxable income and are currently taxed at ordinary income tax rates. NORTH CAROLINA Section 105-134.6(b)(1) of the North Carolina General Statutes provides that interest on exempt obligations of the U.S. government, its possessions, or its territories (including Puerto Rico, Guam and the Virgin Islands) and exempt obligations of the state of North Carolina or its political subdivisions are exempt from state income tax. Pursuant to a North Carolina Department of Revenue Information Release dated October 4, 1990, dividends received from a regulated investment company, such as the North Carolina Fund, are exempt from personal income tax to the extent that the distributions are derived from interest on such exempt obligations. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Distributions of capital gains attributable from the sale of certain North Carolina obligations issued before to July 1, 1995, may be exempt from taxation for the fund's shareholders. Distributions of all net short-term capital gain and net long-term capital gain earned by the fund on all other North Carolina obligations and on non-North Carolina obligations are includable in each shareholder's North Carolina taxable income and are currently taxed at ordinary income rates. TEXAS does not presently impose any income tax on individuals, trusts, or estates. VIRGINIA Section 58.1-322 of the Code of Virginia provides that interest on obligations of the state of Virginia, its political subdivisions, and instrumentalities or direct obligations of the U.S. government or its authorities, commission, instrumentalities or territories (including Puerto Rico, Guam and the Virgin Islands) is exempt from personal income tax. Under Section 23 Virginia Administrative Code 10-110-14, distributions from a regulated investment company, such as the Virginia Fund, also will be exempt from personal income tax if the fund invests in such exempt obligations. Tax-exempt treatment generally is not available for distributions attributable to income earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or for obligations of other states and their political subdivisions. To the extent such investments are made by the fund, such as for temporary or defensive purposes, such distributions generally will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund are included in each shareholder's Virginia taxable income and are currently taxed at ordinary income tax rates. FRANKLIN TAX-FREE TRUST FRANKLIN ARIZONA TAX-FREE INCOME FUND FRANKLIN COLORADO TAX-FREE INCOME FUND FRANKLIN CONNECTICUT TAX-FREE INCOME FUND FRANKLIN FEDERAL INTERMEDIATE-TERM TAX-FREE INCOME FUND FRANKLIN HIGH YIELD TAX-FREE INCOME FUND CLASS FRANKLIN INDIANA TAX-FREE INCOME FUND FRANKLIN MICHIGAN TAX-FREE INCOME FUND FRANKLIN NEW JERSEY TAX-FREE INCOME FUND FRANKLIN OREGON TAX-FREE INCOME FUND FRANKLIN PENNSYLVANIA TAX-FREE INCOME FUND FRANKLIN PUERTO RICO TAX-FREE INCOME FUND STATEMENT OF ADDITIONAL INFORMATION JULY 1, 1999 P.O. BOX 997151, SACRAMENTO, CA 95899-9983 1-800/DIAL BEN(R) - ------------------------------------------------------------------------------- This Statement of Additional Information (SAI) is not a prospectus. It contains information in addition to the information in the funds' prospectus. The funds' prospectus, dated July 1, 1999, which we may amend from time to time, contains the basic information you should know before investing in the funds. You should read this SAI together with the funds' prospectus. The audited financial statements and auditor's report in the trust's Annual Report to Shareholders, for the fiscal year ended February 28, 1999, are incorporated by reference (are legally a part of this SAI). For a free copy of the current prospectus or annual report, contact your investment representative or call 1-800/DIAL BEN (1-800/342-5236). CONTENTS Goals and Strategies ................................. 2 Risks ................................................ 7 Officers and Trustees ................................ 10 Management and Other Services ........................ 13 Portfolio Transactions ............................... 14 Distributions and Taxes .............................. 15 Organization, Voting Rights and Principal Holders ............................... 16 Buying and Selling Shares ............................ 17 Pricing Shares ....................................... 22 The Underwriter ...................................... 23 Performance .......................................... 25 Miscellaneous Information ............................ 29 Description of Ratings ............................... 30 State Tax Treatment .................................. 32 - ------------------------------------------------------------------------------- MUTUAL FUNDS, ANNUITIES, AND OTHER INVESTMENT PRODUCTS: o ARE NOT FEDERALLY INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY OF THE U.S. GOVERNMENT; o ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR ENDORSED BY, ANY BANK; o ARE SUBJECT TO INVESTMENT RISKS, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. - ------------------------------------------------------------------------------- TF3 SAI 07/99 GOALS AND STRATEGIES - ------------------------------------------------------------------------------- The Federal Intermediate Fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes, including the individual alternative minimum tax, as is consistent with prudent investing, while seeking preservation of shareholders' capital. The High Yield Fund's principal investment goal is to provide investors with a high current yield exempt from federal income taxes. Its secondary goal is capital appreciation to the extent possible and consistent with the fund's principal investment goal. The Puerto Rico Fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes as is consistent with prudent investing, while seeking preservation of shareholders' capital. The Puerto Rico Fund also seeks to provide a maximum level of income that is free from the personal income taxes of a majority of states, although this policy is not a fundamental investment goal of the fund and may be changed without shareholder approval. Each state fund's investment goal is to provide investors with as high a level of income exempt from federal income taxes and from personal income taxes for resident shareholders of the fund's state as is consistent with prudent investing, while seeking preservation of shareholders' capital. These goals are fundamental, which means they may not be changed without shareholder approval. Of course, there is no assurance that any fund will meet its goal. As a fundamental policy, each fund normally invests at least 80% of its assets in securities that pay interest free from federal income taxes, including the federal alternative minimum tax. Each fund applies this test to its net assets, except for the Federal Intermediate Fund, which applies this test to its total assets. Each state fund, as a fundamental policy, also normally invests at least 80% of its net assets in securities that pay interest free from the personal income taxes, if any, of its state. As a nonfundamental policy, each state fund and the Puerto Rico Fund also normally invest at least 65% of their total assets in municipal securities of their state or territory. Unlike the state and Puerto Rico Funds, the Federal Intermediate and High Yield Funds are diversified nationally. The High Yield Fund will not invest more than 25% of its total assets in the municipal securities of any one state or territory. Municipal securities issued by a fund's state or that state's counties, municipalities, authorities, agencies, or other subdivisions, generally pay interest free from federal income tax and from state personal income taxes, if any, for residents of the fund's state. Municipal securities issued by U.S. territories such as Guam, Puerto Rico, or the Mariana Islands also generally pay interest free from state personal income taxes in a majority of states. Each fund tries to invest all of its assets in tax-free municipal securities. The issuer's bond counsel generally gives the issuer an opinion on the tax-exempt status of a municipal security when the security is issued. Some states may require a fund to invest a certain amount of its assets in securities of that state, or in securities that are otherwise tax-free under the laws of that state, in order for any portion of the fund's distributions to be free from the state's personal income taxes. If a fund's state requires this, the fund will try to invest its assets as required so that its distributions will be free from personal income taxes for resident shareholder's of the fund's state. As a fundamental policy, the Pennsylvania Fund invests in securities for income earnings rather than trading for profit. The fund does not vary its investments, except to (i) eliminate unsafe investments and investments that are not consistent with the preservation of capital or the tax status of the fund; (ii) honor redemption requests, meet anticipated redemption requirements and negate gains from discount purchases; (iii) reinvest the earnings from securities in like securities; or (iv) defray normal administrative expenses. Below is a description of various types of municipal and other securities that each fund may buy. Other types of municipal securities may become available that are similar to those described below and in which each fund also may invest, if consistent with its investment goal and policies. TAX ANTICIPATION NOTES are issued to finance short-term working capital needs of municipalities in anticipation of various seasonal tax revenues, which will be used to pay the notes. They are usually general obligations of the issuer, secured by the taxing power for the payment of principal and interest. REVENUE ANTICIPATION NOTES are similar to tax anticipation notes except they are issued in expectation of the receipt of other kinds of revenue, such as federal revenues available under the Federal Revenue Sharing Program. BOND ANTICIPATION NOTES are normally issued to provide interim financing until long-term financing can be arranged. Proceeds from long-term bond issues then provide the money for the repayment of the notes. TAX-EXEMPT COMMERCIAL PAPER typically represents a short-term obligation (270 days or less) issued by a municipality to meet working capital needs. MUNICIPAL BONDS meet longer-term capital needs and generally have maturities from one to 30 years when issued. They have two principal classifications: general obligation bonds and revenue bonds. GENERAL OBLIGATION BONDS. Issuers of general obligation bonds include states, counties, cities, towns and regional districts. The proceeds of these obligations are used to fund a wide range of public projects, including construction or improvement of schools, highways and roads. The basic security behind general obligation bonds is the issuer's pledge of its full faith, credit and taxing power for the payment of principal and interest. The taxes that can be levied for the payment of debt service may be limited or unlimited as to the rate or amount of special assessments. REVENUE BONDS. The full faith, credit and taxing power of the issuer do not secure revenue bonds. Instead, the principal security for a revenue bond is generally the net revenue derived from a particular facility, group of facilities, or, in some cases, the proceeds of a special excise tax or other specific revenue source. Revenue bonds are issued to finance a wide variety of capital projects, including: electric, gas, water and sewer systems; highways, bridges and tunnels; port and airport facilities; colleges and universities; and hospitals. The principal security behind these bonds may vary. For example, housing finance authorities have a wide range of security, including partially or fully insured mortgages, rent subsidized and/or collateralized mortgages, and/or the net revenues from housing or other public projects. Many bonds provide additional security in the form of a debt service reserve fund that may be used to make principal and interest payments. Some authorities have further security in the form of state assurances (although without obligation) to make up deficiencies in the debt service reserve fund. TAX-EXEMPT INDUSTRIAL DEVELOPMENT REVENUE BONDS are issued by or on behalf of public authorities to finance various privately operated facilities for business, manufacturing, housing, sports and pollution control, as well as public facilities such as airports, mass transit systems, ports and parking. The payment of principal and interest is solely dependent on the ability of the facility's user to meet its financial obligations and the pledge, if any, of the facility or other property as security for payment. VARIABLE OR FLOATING RATE SECURITIES Each fund may invest in variable or floating rate securities, including variable rate demand notes, which have interest rates that change either at specific intervals (variable rate), from daily up to monthly, or whenever a benchmark rate changes (floating rate). The interest rate adjustments are designed to help stabilize the security's price. While this feature helps protect against a decline in the security's market price when interest rates go up, it lowers the fund's income when interest rates fall. Variable or floating rate securities may include a demand feature, which may be unconditional. The demand feature allows the holder to demand prepayment of the principal amount before maturity, generally on one to 30 days' notice. The holder receives the principal amount plus any accrued interest either from the issuer or by drawing on a bank letter of credit, a guarantee or insurance issued with respect to the security. Each fund generally uses variable or floating rate securities as short-term investments while waiting for long-term investment opportunities. MUNICIPAL LEASE OBLIGATIONS Each fund may invest in municipal lease obligations, including certificates of participation. Municipal lease obligations generally finance the purchase of public property. The property is leased to the state or a local government, and the lease payments are used to pay the interest on the obligations. Municipal lease obligations differ from other municipal securities because the lessee's governing body must appropriate (set aside) the money to make the lease payments each year. If the money is not appropriated, the issuer or the lessee can end the lease without penalty. If the lease is cancelled, investors who own the municipal lease obligations may not be paid. The board of trustees reviews each fund's municipal lease obligations to try to assure that they are liquid investments based on various factors reviewed by the fund's manager and monitored by the board. These factors may include (a) the credit quality of the obligations and the extent to which they are rated or, if unrated, comply with existing criteria and procedures followed to ensure that they are comparable in quality to the ratings required for the fund to invest, including an assessment of the likelihood of the lease being canceled, taking into account how essential the leased property is and the term of the lease compared to the useful life of the leased property; (b) the size of the municipal securities market, both in general and with respect to municipal lease obligations; and (c) the extent to which the type of municipal lease obligations held by the fund trade on the same basis and with the same degree of dealer participation as other municipal securities of comparable credit rating or quality. Since annual appropriations are required to make lease payments, municipal lease obligations generally are not subject to constitutional limitations on the issuance of debt and may allow an issuer to increase government liabilities beyond constitutional debt limits. When faced with increasingly tight budgets, local governments have more discretion to curtail lease payments under a municipal lease obligation than they do to curtail payments on other municipal securities. If not enough money is appropriated to make the lease payments, the leased property may be repossessed as security for holders of the municipal lease obligations. If this happens, there is no assurance that the property's private sector or re-leasing value will be enough to make all outstanding payments on the municipal lease obligations or that the payments will continue to be tax-free. While cancellation risk is inherent to municipal lease obligations, each fund, except the High Yield Fund, believes that this risk may be reduced, although not eliminated, by its policies on the quality of securities in which it may invest. CALLABLE BONDS Each fund may invest in callable bonds, which allow the issuer to repay some or all of the bonds ahead of schedule. If a bond is called, the fund will receive the principal amount, the accrued interest, and may receive a small additional payment as a call premium. The manager may sell a callable bond before its call date, if it believes the bond is at its maximum premium potential. When pricing callable bonds, the call feature is factored into the price of the bonds and may impact the fund's net asset value. An issuer is more likely to call its bonds when interest rates are falling, because the issuer can issue new bonds with lower interest payments. If a bond is called, the fund may have to replace it with a lower-yielding security. A call of some or all of these securities may lower a fund's income and its distributions to shareholders. If the fund originally paid a premium for the bond because it had appreciated in value from its original issue price, the fund also may not be able to recover the full amount it paid for the bond. One way for the fund to protect itself from call risk is to buy bonds with call protection. Call protection is an assurance that the bond will not be called for a specific time period, typically five to 10 years from when the bond is issued. ESCROW-SECURED OR DEFEASED BONDS are created when an issuer refunds, before maturity, an outstanding bond issue that is not immediately callable (or pre-refunds), and sets aside funds for redemption of the bonds at a future date. The issuer uses the proceeds from a new bond issue to buy high grade, interest bearing debt securities, generally direct obligations of the U.S. government. These securities are then deposited in an irrevocable escrow account held by a trustee bank to secure all future payments of principal and interest on the pre-refunded bond. Escrow-secured bonds often receive a triple A or equivalent rating. STRIPPED MUNICIPAL SECURITIES Municipal securities may be sold in "stripped" form. Stripped municipal securities represent separate ownership of principal and interest payments on municipal securities. ZERO-COUPON SECURITIES Each fund may invest in zero-coupon and delayed interest securities. Zero-coupon securities make no periodic interest payments, but are sold at a deep discount from their face value. The buyer recognizes a rate of return determined by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. The discount varies depending on the time remaining until maturity, as well as market interest rates, liquidity of the security, and the issuer's perceived credit quality. The discount, in the absence of financial difficulties of the issuer, typically decreases as the final maturity date approaches. If the issuer defaults, the fund may not receive any return on its investment. Because zero-coupon securities bear no interest and compound semiannually at the rate fixed at the time of issuance, their value is generally more volatile than the value of other fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zero-coupon securities fall more dramatically than bonds paying interest on a current basis when interest rates rise. When interest rates fall, zero-coupon securities rise more rapidly in value, because the bonds reflect a fixed rate of return. An investment in zero-coupon and delayed interest securities may cause a fund to recognize income and make distributions to shareholders before it receives any cash payments on its investment. To generate cash to satisfy distribution requirements, a fund may have to sell portfolio securities that it otherwise would have continued to hold or to use cash flows from other sources such as the sale of fund shares. CONVERTIBLE AND STEP COUPON BONDS Each fund may invest a portion of its assets in convertible and step coupon bonds. Convertible bonds are zero-coupon securities until a predetermined date, at which time they convert to a specified coupon security. The coupon on step coupon bonds changes periodically during the life of the security based on predetermined dates chosen when the security is issued. U.S. GOVERNMENT OBLIGATIONS are issued by the U.S. Treasury or by agencies and instrumentalities of the U.S. government and are backed by the full faith and credit of the U.S. government. They include Treasury bills, notes and bonds. COMMERCIAL PAPER is a promissory note issued by a corporation to finance its short-term credit needs. Each fund may invest in taxable commercial paper only for temporary defensive purposes. WHEN-ISSUED TRANSACTIONS Municipal securities are frequently offered on a "when-issued" basis. When so offered, the price, which is generally expressed in yield terms, is fixed at the time the commitment to buy is made, but delivery and payment take place at a later date. During the time between purchase and settlement, no payment is made by the fund to the issuer and no interest accrues to the fund. If the other party to the transaction fails to deliver or pay for the security, the fund could miss a favorable price or yield opportunity, or could experience a loss. When a fund makes the commitment to buy a municipal security on a when-issued basis, it records the transaction and reflects the value of the security in the determination of its net asset value. The funds believe their net asset value or income will not be negatively affected by their purchase of municipal securities on a when-issued basis. The funds will not engage in when-issued transactions for investment leverage purposes. Although a fund will generally buy municipal securities on a when-issued basis with the intention of acquiring the securities, it may sell the securities before the settlement date if it is considered advisable. When a fund is the buyer, it will maintain cash or liquid securities, with an aggregate value equal to the amount of its purchase commitments, in a segregated account with its custodian bank until payment is made. If assets of a fund are held in cash pending the settlement of a purchase of securities, the fund will not earn income on those assets. ILLIQUID INVESTMENTS Each fund may invest up to 10% of its net assets in illiquid securities. Illiquid securities are generally securities that cannot be sold within seven days in the normal course of business at approximately the amount at which the fund has valued them. DIVERSIFICATION All of the funds, except the Connecticut, Federal Intermediate and Michigan Funds, are diversified funds. The Connecticut, Federal Intermediate and Michigan Funds are non-diversified. As a fundamental policy, none of the diversified funds will buy a security if, with respect to 75% of its net assets, more than 5% would be in the securities of any single issuer (with the exception of obligations of the U.S. government). For this purpose, each political subdivision, agency, or instrumentality, each multi-state agency of which a state is a member, and each public authority that issues private activity bonds on behalf of a private entity, is considered a separate issuer. Escrow-secured or defeased bonds are not generally considered an obligation of the original municipality when determining diversification. Each fund, including the Connecticut, Federal Intermediate and Michigan Funds, intends to meet certain diversification requirements for tax purposes. Generally, to meet federal tax requirements at the close of each quarter, a fund may not invest more than 25% of its total assets in any one issuer and, with respect to 50% of total assets, may not invest more than 5% of its total assets in any one issuer. These limitations do not apply to U.S. government securities and may be revised if applicable federal income tax requirements are revised. TEMPORARY INVESTMENTS When the manager believes the securities trading markets or the economy are experiencing excessive volatility or a prolonged general decline, or other unusual or adverse conditions exist, including the unavailability of securities that meet a fund's investment criteria, it may invest each fund's portfolio in a temporary defensive manner. Under these circumstances, each fund may invest all of its assets in securities that pay taxable interest, including (i) high quality commercial paper; (ii) securities issued or guaranteed by the full faith and credit of the U.S. government; or (iii) for the state and Puerto Rico Funds, municipal securities issued by a state, territory or local government other than the fund's state or territory. Each fund also may invest all of its assets in municipal securities issued by a U.S. territory such as Guam, Puerto Rico or the Mariana Islands. SECURITIES TRANSACTIONS The frequency of portfolio transactions, usually referred to as the portfolio turnover rate, varies for each fund from year to year, depending on market conditions. While short-term trading increases portfolio turnover and may increase costs, the execution costs for municipal securities are substantially less than for equivalent dollar values of equity securities. CREDIT QUALITY All things being equal, the lower a security's credit quality, the higher the risk and the higher the yield the security generally must pay as compensation to investors for the higher risk. A security's credit quality depends on the issuer's ability to pay interest on the security and, ultimately, to repay the principal. Independent rating agencies, such as Fitch Investors Service Inc. (Fitch), Moody's Investors Service, Inc. (Moody's), and Standard & Poor's Corporation (S&P), often rate municipal securities based on their opinion of the issuer's credit quality. Most rating agencies use a descending alphabet scale to rate long-term securities, and a descending numerical scale to rate short-term securities. These ratings are described at the end of this SAI under "Description of Ratings." An insurance company, bank or other foreign or domestic entity may provide credit support for a municipal security and enhance its credit quality. For example, some municipal securities are insured, which means they are covered by an insurance policy that guarantees the timely payment of principal and interest. Other municipal securities may be backed by letters of credit, guarantees, or escrow or trust accounts that contain securities backed by the full faith and credit of the U.S. government to secure the payment of principal and interest. As discussed in the prospectus, each fund has limitations on the credit quality of the securities it may buy. These limitations are generally applied when a fund makes an investment so that a fund is not required to sell a security because of a later change in circumstances. The High Yield Fund invests at least 65% of its assets in high yield securities. The High Yield Fund may invest in securities rated in any rating category, including defaulted securities if the manager believes the issuer may resume making interest payments or other favorable developments seem likely in the near future. The High Yield Fund, however, currently does not intend to invest more than 10% of its assets in defaulted securities. While the fund tries to invest in lower-rated securities, the manager may consider existing market conditions, the availability of lower-rated securities, and whether the difference in yields between higher- and lower-rated securities justifies the higher risk of lower-rated securities when selecting securities for the High Yield Fund's portfolio. INVESTMENT RESTRICTIONS Each fund has adopted the following restrictions as fundamental policies. This means they may only be changed if the change is approved by (i) more than 50% of the fund's outstanding shares or (ii) 67% or more of the fund's shares present at a shareholder meeting if more than 50% of the fund's outstanding shares are represented at the meeting in person or by proxy, whichever is less. Each fund may not: 1. Borrow money or mortgage or pledge any of its assets, except that borrowings (and a pledge of assets therefore) for temporary or emergency purposes may be made from banks in any amount up to 5% of the total asset value. 2. Buy any securities on "margin" or sell any securities "short," except that it may use such short-term credits as are necessary for the clearance of transactions. 3. Make loans, except through the purchase of readily marketable debt securities which are either publicly distributed or customarily purchased by institutional investors. Although such loans are not presently intended, this prohibition will not preclude the fund from loaning portfolio securities to broker-dealers or other institutional investors if at least 102% cash collateral is pledged and maintained by the borrower; provided such portfolio security loans may not be made if, as a result, the aggregate of such loans exceeds 10% of the value of the fund's total assets at the time of the most recent loan. 4. Act as underwriter of securities issued by other persons, except insofar as the fund may be technically deemed an underwriter under the federal securities laws in connection with the disposition of portfolio securities. 5. Purchase the securities of any issuer which would result in owning more than 10% of the voting securities of such issuer, except with respect to the Connecticut and Federal Intermediate Funds, each of which will not purchase a security, if as a result: i) more than 25% of its total assets would be invested in the securities of a single issuer or ii) with respect to 50% of its total assets, more than 5% of its assets would be invested in the securities of a single issuer. 6. Purchase securities from or sell to the trust's officers and trustees, or any firm of which any officer or trustee is a member, as principal, or retain securities of any issuer if, to the knowledge of the trust, one or more of the trust's officers, trustees, or investment manager own beneficially more than one-half of 1% of the securities of such issuer and all such officers and trustees together own beneficially more than 5% of such securities. 7. Acquire, lease or hold real estate, except such as may be necessary or advisable for the maintenance of its offices and provided that this limitation shall not prohibit the purchase of municipal and other debt securities secured by real estate or interests therein. 8. Invest in commodities and commodity contracts, puts, calls, straddles, spreads or any combination thereof, or interests in oil, gas, or other mineral exploration or development programs, except that it may purchase, hold and dispose of "obligations with puts attached" in accordance with its investment policies. 9. Invest in companies for the purpose of exercising control or management. 10. For each fund except the Federal Intermediate Fund, purchase securities of other investment companies, except in connection with a merger, consolidation or reorganization, except to the extent the fund invests its uninvested daily cash balances in shares of the Franklin Tax-Exempt Money Fund and other tax-exempt money market funds in the Franklin Templeton Group of Funds provided i) its purchases and redemptions of such money market fund shares may not be subject to any purchase or redemption fees, ii) its investments may not be subject to duplication of management fees, nor to any charge related to the expense of distributing the fund's shares (as determined under Rule 12b-1, as amended under the federal securities laws) and iii) aggregate investments by the fund in any such money market fund do not exceed (A) the greater of (i) 5% of the fund's total net assets or (ii) $2.5 million, or (B) more than 3% of the outstanding shares of any such money market fund. 11. For each fund except the Federal Intermediate Fund, invest more than 25% of its assets in securities of any industry; although for purposes of this limitation, tax-exempt securities and U.S. government obligations are not considered to be part of any industry. The following investment restrictions only apply to the Federal Intermediate Fund: 12. Purchase securities of other investment companies, except in connection with a merger, consolidation, acquisition or reorganization. To the extent permitted by exemptions which may be granted under the Investment Company Act of 1940, the Federal Intermediate Fund may invest in shares of one or more investment companies, of the type generally referred to as money market funds, managed by Franklin Advisers, Inc. or its affiliates. 13. Purchase securities, in private placements or in other transactions, for which there are legal or contractual restrictions on resale. 14. Invest more than 25% of its assets in securities of any industry. For purposes of this limitation, tax-exempt securities issued by governments or political subdivisions of governments are not considered to be part of any industry. If a bankruptcy or other extraordinary event occurs concerning a particular security the fund owns, the fund may receive stock, real estate, or other investments that the fund would not, or could not, buy. If this happens, the fund intends to sell such investments as soon as practicable while maximizing the return to shareholders. Generally, the policies and restrictions discussed in this SAI and in the prospectus apply when the fund makes an investment. In most cases, the fund is not required to sell a security because circumstances change and the security no longer meets one or more of the fund's policies or restrictions. If a percentage restriction or limitation is met at the time of investment, a later increase or decrease in the percentage due to a change in the value or liquidity of portfolio securities will not be considered a violation of the restriction or limitation. RISKS - ------------------------------------------------------------------------------- STATE Since each state fund mainly invests in the municipal securities of its state, its performance is closely tied to the ability of issuers of municipal securities in its state to continue to make principal and interest payments on their securities. The issuers' ability to do this is in turn dependent on economic, political and other conditions within the state. Below is a discussion of certain conditions that may affect municipal issuers in the funds' various states. It is not a complete analysis of every material fact that may affect the ability of issuers of municipal securities to meet their debt obligations or the economic or political conditions within any state and is subject to change. The information below is based on data available to the funds from historically reliable sources, but the funds have not independently verified it. The ability of issuers of municipal securities to continue to make principal and interest payments is dependent in large part on their ability to raise revenues, primarily through taxes, and to control spending. Many factors can affect a state's revenues including the rate of population growth, unemployment rates, personal income growth, federal aid, and the ability to attract and keep successful businesses. A number of factors can also affect a state's spending including current debt levels, and the existence of accumulated budget deficits. The following provides some information on these and other factors. ARIZONA. Strong overall employment growth, affordable housing, and an attractive climate have helped Arizona's population grow at a rate four times faster than the national rate during the 1990s. Although population growth is expected to remain strong in the near term, the rate of growth has slowed since 1996 as a result of California's economic recovery and thus less migration from that state. Competitive wage rates, low energy costs, corporate tax reductions and an abundance of land also have helped to attract businesses to the state. As a result, Arizona's unemployment in 1998 was at its lowest level since the early 1970s. Arizona's economy has continued to diversify, especially in the manufacturing and services areas. As of August 1998, manufacturing accounted for approximately 10.5% of the state's total employment, trade 24.3%, services 30.4%, government 16.1%, and construction 6.6%. Farming and mining accounted for less than 2% of the total workforce. Improved diversification may help reduce the state's economic vulnerability that in the past resulted from Arizona's historical dependence on its farming, mining and real estate industries. Arizona may be vulnerable, however, to events affecting high-technology products and to recent and future economic problems in Asia. Approximately 80% of the state's exports have been in the area of high-technology products and Asian exports have supported at least 100,000 jobs in the state. Under its constitution, Arizona cannot issue general obligation debt. Thus, gross state debt levels have remained moderate. The state historically has relied on lease obligations, revenue bonds, and pay-as-you-go financing for its capital needs. Arizona's strong economic growth and higher-than-anticipated tax revenues have allowed the state to post four consecutive operating surpluses and general fund balance increases. Preliminary 1998 results show another operating surplus. During fiscal 1999, however, a reduction in the general fund balance is expected with the implementation of new school capital funding legislation. COLORADO. During the 1980s, Colorado's economy was dependent on its energy sector. As a result, the state suffered a sharp economic downturn when the energy sector declined in the mid-to-late 1980s. Since 1991, growth in the services, trade and government sectors has improved Colorado's economic diversification. Growth in these areas, as well as in construction and high technology sectors, also has helped to offset job losses caused by military base closings and the decline of the state's mining industry. Population and income levels have also grown since 1991, often exceeding national trends, and unemployment levels have been below the national average. The recent strength of Colorado's economy has helped to improve the state's financial position. Revenue growth has continued to exceed projections, primarily in the area of income tax collections. Since Colorado's constitution prohibits the issuance of general obligation debt, the state's debt burden has been low. The state has relied primarily on pay-as-you-go and lease financing to meet its capital improvement needs. CONNECTICUT. Connecticut's recovery from the recession of the early 1990s has been slower than the rest of the nation. Over the past two years, however, the state's economic recovery has shown signs of improved strength. Gains in tourism and business services have led to greater economic diversification as the economy has continued to move from manufacturing and defense related industries towards services. Although manufacturing still represented over 16% of the state's employment base in 1998, the services sector accounted for more than 31% of employment. Connecticut has sought to further its economic growth with various business and tax incentives such as corporate and sales tax rate cuts, corporate tax credits for research and development and various other business tax credits. Nonetheless, the state's tight labor market, slow population growth and high wages may limit future growth. The state's financial results have been positive in recent years, with budget surpluses for the past seven years. Connecticut's improved financial performance has resulted in part from various fiscal reforms including a constitutional amendment requiring balanced budgets, expenditure caps and the implementation of a personal income tax. These improvements have allowed the state to fully fund its rainy day reserve. Potential areas of financial stress may include increased spending for education, an unfunded pension liability, and a relatively high debt burden. INDIANA. Despite some diversification, Indiana's economy has remained dependent on its durable goods manufacturing sector. As of February 1999, manufacturing accounted for 24% of all jobs in the state, the highest percentage in the U.S. The state's reliance on manufacturing makes it more vulnerable to domestic and international business cycles than more diverse states. The state's employment growth has been slow in recent years and its already tight labor market could further constrain future growth. Financially, the state's performance has been positive. The state ended fiscal 1998 with a surplus and was able to further increase its reserves. At the end of fiscal 1998, Indiana's reserve levels were among the strongest in the nation. The state, however, has a significant unfunded pension liability that totaled $7.2 billion as of January 1999. To address this problem, the state has created a pension stabilization fund. The state hopes that appropriations to the stabilization fund will help limit the effect of the liability on the state's general fund. MICHIGAN. While Michigan's economy has diversified to some degree, it has remained dependent on its durable goods manufacturing sector, especially on its cyclical auto industry. In recent years, manufacturing has accounted for 22% of the state's employment and 33% of personal income. While this sector has been strong since the end of the national recession in the early 1990s and has made improvements that could potentially lessen its historical volatility, the state's reliance on manufacturing has made its economy potentially more volatile than the economies of more diverse states and more susceptible to the adverse effects of another recession. Since 1992, Michigan's economy has grown at a healthy pace. Unemployment levels have been below national levels since 1994 and, through September 1998, employment levels were at an all-time high. With the help of its strong economy, Michigan's finances also have improved. Tighter budget controls and the positive effect on revenues of the state's relatively strong economy have allowed the state to replenish reserves, which had been severely depleted during the early 1990s. The state's budget stabilization fund was at more than $1 billion at September 30, 1998. Michigan may need the increased stability these reserve levels provide to offset higher school funding requirements. The state also has been able to maintain its traditionally low debt levels, although contingent debt levels issued through school programs and based on the state's credit have grown rapidly, approaching levels almost double the state's outstanding direct debt. The state's contingent debt exposure will need to be carefully managed in the coming years to help maintain the state's financial stability. NEW JERSEY. Historically, New Jersey's economy has been one of the most diverse in the nation. Like many other states in the northeast region, New Jersey was hit especially hard by the recession in the early 1990s and has been slower to recover than many other states. Over the past two years, however, the state's performance has improved. Jobs grew at a rate of 2.3% in 1997 and 2% in 1998. While these rates were below the national rates of 2.5% in 1997 and 2.6% in 1998, they led the region. Unemployment levels also have decreased to 4.8% in 1998, slightly above the national rate of 4.5%. The state ended fiscal 1998 with a surplus and increased its fund balances to $1.25 billion. The state's positive financial performance was aided by strong growth in personal income tax receipts. Much of this growth was from the high-income taxpayer base, which grew due in part to the recent success of the financial services sector. The state's increased reliance on high-income taxpayers and the success of the financial markets may make it more vulnerable to an economic downturn. The state's outstanding debt has grown significantly in recent years. As of January 1999, the state ranked near the top in net tax-supported debt, ratio of debt to personal income and debt per capita. Nonetheless, debt service has remained manageable in light of the state's resources. OREGON. Oregon's economy has experienced strong growth, primarily in its hi-tech manufacturing and housing construction sectors. Growth has slowed recently, however, due to economic troubles in Asia. Future growth is likely to be dependent on the continued strength of the national economy, as well as the strength of the state's hi-tech industries, and the performance of Pacific Rim economies. Economic growth may be hampered, however, by the state's rising labor and housing costs, which have lessened Oregon's competitive position in attracting new businesses. The strength of Oregon's economy has helped the state maintain positive financial results. Recently, however, voter initiatives have limited the state's financial flexibility. In November 1990, voters approved Measure 5, which limited local property taxes and required the state to provide replacement revenues to schools. As of March 1999, the state has been successful in meeting the requirements of Measure 5, which has increased state spending for schools from 33% of the general fund budget to more than 40%. On May 20, 1997, voters passed Measure 50, which has placed some pressure on the state's budget. This measure could negatively impact the revenue-raising flexibility of the state and make it more vulnerable to an economic downturn. PENNSYLVANIA. Although improving, the performance of Pennsylvania's economy has continued to lag the national average. The largest growth areas have been business, health care, and consumer services, which have helped to offset declines in the manufacturing, mining and machinery sectors. Overall, job growth was 0.9% from April 1998 to April 1999, compared to a national rate of 2.5%. Population and personal income growth also have remained below national levels. To try to improve its economic performance, Pennsylvania recently made economic development a priority. To attract new business, the commonwealth has implemented various business tax cuts and has attempted to ease its regulatory environment. These steps, together with the commonwealth's strong education, health care and transportation systems, could help to provide a positive environment for attracting businesses. Historically, Pennsylvania's financial performance has been tied to fluctuations in both national and regional economic trends. In recent years, improvements in the commonwealth's economy and higher-than-expected tax revenues have helped strengthen the commonwealth's financial position. The commonwealth ended fiscal 1998 with an operating surplus and increased its reserve levels. Due to the cyclical nature of its economy and financial performance, the commonwealth has been committed to using surpluses to build reserves, rather than to increase spending, in the hope of providing some security against future economic downturns or other uncertainties that could affect the state. U.S. TERRITORIES Since each fund may invest a portion of its assets in municipal securities issued by U.S. territories, and the Puerto Rico Fund invests mainly in Puerto Rico municipal securities, the ability of municipal issuers in U.S. territories to continue to make principal and interest payments also may affect a fund's performance. As with state municipal issuers, the ability to make these payments is dependent on economic, political and other conditions. Below is a discussion of certain conditions within some of the territories where the funds may be invested. It is not a complete analysis of every material fact that may affect the ability of issuers of U.S. territory municipal securities to meet their debt obligations or the economic or political conditions within the territories and is subject to change. It is based on data available to the funds from historically reliable sources, but it has not been independently verified by the funds. GUAM. Guam's economy has been heavily dependent on tourism. It has been especially dependent on Japanese tourism, which has made Guam vulnerable to fluctuations in the relationship between the U.S. dollar and the Japanese yen. The recent Asian economic crisis and Typhoon Paka, which hit Guam in December 1997, negatively affected both tourism and other economic activities in Guam and contributed to a decline of 1.8% in gross island product between 1997 and 1998. In the early to mid-1990s, Guam's financial position deteriorated due to a series of natural disasters that led to increased spending on top of already significant budget gaps. As a result, the government introduced a comprehensive financial plan in June 1995 to help balance the budget and reduce the general fund deficit by fiscal 1999. For fiscal 1998, however, Guam incurred a $21 million deficit and ended the year with a negative unreserved general fund balance of $158.9 million. Another deficit is expected in 1999. While Guam's debt burden has been manageable, Guam's ability to maintain current debt levels may be challenged in the near future. U.S. military downsizing has reduced the federal presence on the island and also may reduce federal support for infrastructure projects. At the same time, Guam has faced increasing pressure to improve its infrastructure to help generate economic development. Overall, as of May 20, 1999, S&P's outlook for Guam was negative due to Guam's continued weak financial position and inability to meet the goals of the financial plan. MARIANA ISLANDS. The Mariana Islands became a commonwealth in 1975. At that time, the U.S. government agreed to exempt the islands from federal minimum wage and immigration laws in an effort to help stimulate industry and the economy. The islands' minimum wage has been more than $2 per hour below the U.S. level and tens of thousands of workers have immigrated from various Asian countries to provide cheap labor for the islands' industries. Recently, the islands' tourism and apparel industries combined to help increase gross business receipts from $224 million in 1985 to $2 billion in 1996. PUERTO RICO. Overall, Moody's considered Puerto Rico's outlook stable as of January 1999. In recent years, Puerto Rico's financial performance has improved. Relatively strong revenue growth and more aggressive tax collection procedures resulted in a general fund surplus for fiscal 1998 (unaudited). For fiscal 1999, spending increases of 11% are budgeted, which may create an operating deficit and deplete the commonwealth's unreserved fund balance. Puerto Rico's debt levels have been high. Going forward, these levels may increase as Puerto Rico attempts to finance significant capital and infrastructure improvements. Puerto Rico also will need to address its large unfunded pension liability of more than $6 billion. Despite Puerto Rico's stable outlook, Puerto Rico may face challenges in the coming years with the 1996 passage of a bill eliminating section 936 of the Internal Revenue Code. This section has given certain U.S. corporations operating in Puerto Rico significant tax advantages. These incentives have helped considerably with Puerto Rico's economic growth, especially with the development of its manufacturing sector. U.S. firms that have benefited from these incentives have provided a significant portion of Puerto Rico's revenues, employment and deposits in local financial institutions. The section 936 incentives will be phased out over a 10-year period ending in 2006. It is hoped that this long phase-out period will give Puerto Rico sufficient time to lessen the potentially negative effects of section 936's elimination. Outstanding issues relating to the potential for a transition to statehood also may have broad implications for Puerto Rico and its financial and credit position. CREDIT (HIGH YIELD FUND ONLY) Since the High Yield Fund may invest in municipal securities rated below investment grade, an investment in the fund is subject to a higher degree of risk than an investment in a fund that invests primarily in higher-quality securities. The market value of high yield, lower-quality municipal securities tends to reflect individual developments affecting the issuer to a greater degree than the market value of higher-quality securities, which react primarily to fluctuations in the general level of interest rates. Lower-quality securities also tend to be more sensitive to economic conditions than higher-quality securities. Factors adversely affecting the market value of high yield securities may lower the fund's net asset value and affect its performance. Projects financed by high yield municipal securities are often highly leveraged and may not have more traditional methods of financing available to them. Therefore, the risk associated with buying these securities is generally greater than the risk associated with higher-quality securities. For example, during an economic downturn or a sustained period of rising interest rates, projects financed by lower-quality securities may experience financial stress and may not have sufficient cash flow to make interest payments. The issuer's ability to make timely interest and principal payments also may be adversely affected by specific developments affecting the issuer, including the issuer's inability to meet specific projected revenue forecasts or the unavailability of additional financing. The risk of loss due to default also may be considerably greater with lower-quality securities. If the issuer of a security in the fund's portfolio defaults, the fund may have unrealized losses on the security, which may lower the fund's net asset value. Defaulted securities tend to lose much of their value before they default. Thus, the fund's net asset value may be adversely affected before an issuer defaults. In addition, the fund may incur additional expenses if it must try to recover principal or interest payments on a defaulted security. Lower-quality securities may not be as liquid as higher-quality securities. Reduced liquidity in the secondary market may have an adverse impact on the market price of a security and on the fund's ability to sell a security in response to a specific economic event, such as a deterioration in the creditworthiness of the issuer, or if necessary to meet the fund's liquidity needs. Reduced liquidity also may make it more difficult to obtain market quotations based on actual trades for purposes of valuing the fund's portfolio. The following table provides a summary of the credit quality of the High Yield Fund's portfolio. These figures are dollar-weighted averages of month-end assets during the fiscal year ended February 28, 1999. AVERAGE WEIGHTED S&P RATING PERCENTAGE OF ASSETS - -------------------------------------------------------------- AAA 24.0 1 AA 2.2 A 8.5 2 BBB 20.6 3 BB 27.3 4 B 8.7 5 CCC 1.2 Not Rated 7.5 6 1. 9.2% are unrated and have been included in the AAA rating category. 2. 0.4% are unrated and have been included in the A rating category. 3. 7.1% are unrated and have been included in the BBB rating category. 4. 15.8% are unrated and have been included in the BB rating category. 5. 1.1% are unrated and have been included in the B rating category. 6. This figure includes securities that have not been rated by S&P but that have been rated by another rating agency. OFFICERS AND TRUSTEES - ------------------------------------------------------------------------------- The trust has a board of trustees. The board is responsible for the overall management of the trust, including general supervision and review of each fund's investment activities. The board, in turn, elects the officers of the trust who are responsible for administering the trust's day-to-day operations. The board also monitors each fund to ensure no material conflicts exist among share classes. While none is expected, the board will act appropriately to resolve any material conflict that may arise. The name, age and address of the officers and board members, as well as their affiliations, positions held with the trust, and principal occupations during the past five years are shown below. Frank H. Abbott, III (78) 1045 Sansome Street, San Francisco, CA 94111 TRUSTEE President and Director, Abbott Corporation (an investment company); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, MotherLode Gold Mines Consolidated (gold mining) and Vacu-Dry Co. (food processing). Harris J. Ashton (67) 191 Clapboard Ridge Road, Greenwich, CT 06830 TRUSTEE Director, RBC Holdings, Inc. (bank holding company) and Bar-S Foods (meat packing company); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, President, Chief Executive Officer and Chairman of the Board, General Host Corporation (nursery and craft centers). S. Joseph Fortunato (66) Park Avenue at Morris County, P.O. Box 1945 Morristown, NJ 07962-1945 TRUSTEE Member of the law firm of Pitney, Hardin, Kipp & Szuch; director or trustee, as the case may be, of 50 of the investment companies in the Franklin Templeton Group of Funds. Edith E. Holiday (47) 3239 38th Street, N.W., Washington, DC 20016 TRUSTEE Director, Amerada Hess Corporation (exploration and refining of natural gas) (1993-present), Hercules Incorporated (chemicals, fibers and resins) (1993-present), Beverly Enterprises, Inc. (health care) (1995-present) and H.J. Heinz Company (processed foods and allied products) (1994-present); director or trustee, as the case may be, of 24 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman (1995-1997) and Trustee (1993-1997), National Child Research Center, Assistant to the President of the United States and Secretary of the Cabinet (1990-1993), General Counsel to the United States Treasury Department (1989-1990), and Counselor to the Secretary and Assistant Secretary for Public Affairs and Public Liaison - United States Treasury Department (1988-1989). *Charles B. Johnson (66) 777 Mariners Island Blvd., San Mateo, CA 94404 CHAIRMAN OF THE BOARD AND TRUSTEE President, Chief Executive Officer and Director, Franklin Resources, Inc.; Chairman of the Board and Director, Franklin Advisers, Inc., Franklin Investment Advisory Services, Inc. and Franklin Templeton Distributors, Inc.; Director, Franklin/Templeton Investor Services, Inc. and Franklin Templeton Services, Inc.; officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 49 of the investment companies in the Franklin Templeton Group of Funds. *Rupert H. Johnson, Jr. (58) 777 Mariners Island Blvd., San Mateo, CA 94404 PRESIDENT AND TRUSTEE Executive Vice President and Director, Franklin Resources, Inc. and Franklin Templeton Distributors, Inc.; President and Director, Franklin Advisers, Inc. and Franklin Investment Advisory Services, Inc.; Senior Vice President, Franklin Advisory Services, LLC; Director, Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Frank W.T. LaHaye (70) 20833 Stevens Creek Blvd., Suite 102, Cupertino, CA 95014 TRUSTEE General Partner, Miller & LaHaye, which is the General Partner of Peregrine Ventures II (venture capital firm); director or trustee, as the case may be, of 27 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Director, Fischer Imaging Corporation (medical imaging systems), Digital Transmission Systems, Inc. (wireless communications) and Quarterdeck Corporation (software firm), and General Partner, Peregrine Associates, which was the General Partner of Peregrine Ventures (venture capital firm). Gordon S. Macklin (71) 8212 Burning Tree Road, Bethesda, MD 20817 TRUSTEE Director, Fund American Enterprises Holdings, Inc. (holding company), Martek Biosciences Corporation, MCI WorldCom (information services), MedImmune, Inc. (biotechnology), Spacehab, Inc. (aerospace services) and Real 3D (software); director or trustee, as the case may be, of 48 of the investment companies in the Franklin Templeton Group of Funds; and FORMERLY, Chairman, White River Corporation (financial services) and Hambrecht and Quist Group (investment banking), and President, National Association of Securities Dealers, Inc. Harmon E. Burns (54) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President and Director, Franklin Resources, Inc., Franklin Templeton Distributors, Inc. and Franklin Templeton Services, Inc.; Executive Vice President, Franklin Advisers, Inc.; Director, Franklin Investment Advisory Services, Inc. and Franklin/Templeton Investor Services, Inc.; and officer and/or director or trustee, as the case may be, of most of the other subsidiaries of Franklin Resources, Inc. and of 52 of the investment companies in the Franklin Templeton Group of Funds. Martin L. Flanagan (39) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Senior Vice President and Chief Financial Officer, Franklin Resources, Inc., Franklin/Templeton Investor Services, Inc. and Franklin Mutual Advisers, LLC; Executive Vice President, Chief Financial Officer and Director, Templeton Worldwide, Inc.; Executive Vice President, Chief Operating Officer and Director, Templeton Investment Counsel, Inc.; Executive Vice President and Chief Financial Officer, Franklin Advisers, Inc.; Chief Financial Officer, Franklin Advisory Services, LLC and Franklin Investment Advisory Services, Inc.; President and Director, Franklin Templeton Services, Inc.; officer and/or director of some of the other subsidiaries of Franklin Resources, Inc.; and officer and/or director or trustee, as the case may be, of 52 of the investment companies in the Franklin Templeton Group of Funds. Deborah R. Gatzek (50) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT AND SECRETARY Senior Vice President and General Counsel, Franklin Resources, Inc.; Senior Vice President, Franklin Templeton Services, Inc. and Franklin Templeton Distributors, Inc.; Executive Vice President, Franklin Advisers, Inc.; Vice President, Franklin Advisory Services, LLC and Franklin Mutual Advisers, LLC; Vice President, Chief Legal Officer and Chief Operating Officer, Franklin Investment Advisory Services, Inc.; and officer of 53 of the investment companies in the Franklin Templeton Group of Funds. Thomas J. Kenny (36) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Executive Vice President, Franklin Advisers, Inc.; and officer of eight of the investment companies in the Franklin Templeton Group of Funds. Diomedes Loo-Tam (60) 777 Mariners Island Blvd., San Mateo, CA 94404 TREASURER AND PRINCIPAL ACCOUNTING OFFICER Senior Vice President, Franklin Templeton Services, Inc.; and officer of 32 of the investment companies in the Franklin Templeton Group of Funds. Edward V. McVey (61) 777 Mariners Island Blvd., San Mateo, CA 94404 VICE PRESIDENT Senior Vice President and National Sales Manager, Franklin Templeton Distributors, Inc.; and officer of 28 of the investment companies in the Franklin Templeton Group of Funds. *This board member is considered an "interested person" under federal securities laws. Note: Charles B. Johnson and Rupert H. Johnson, Jr. are brothers. The trust pays noninterested board members $1,450 per month plus $1,300 per meeting attended. Board members who serve on the audit committee of the trust and other funds in the Franklin Templeton Group of Funds receive a flat fee of $2,000 per committee meeting attended, a portion of which is allocated to the trust. Members of a committee are not compensated for any committee meeting held on the day of a board meeting. Noninterested board members also may serve as directors or trustees of other funds in the Franklin Templeton Group of Funds and may receive fees from these funds for their services. The fees payable to noninterested board members by the trust are subject to reductions resulting from fee caps limiting the amount of fees payable to board members who serve on other boards within the Franklin Templeton Group of Funds. The following table provides the total fees paid to noninterested board members by the trust and by the Franklin Templeton Group of Funds. NUMBER OF BOARDS IN TOTAL FEES THE FRANKLIN RECEIVED FROM TEMPLETON TOTAL FEES THE FRANKLIN GROUP RECEIVED TEMPLETON OF FUNDS FROM THE GROUP ON WHICH NAME TRUST 1 OF FUNDS 2 EACH SERVES 3 - ------------------------------------------------------------------------------- Frank H. Abbott, III $25,675 $159,051 27 Harris J. Ashton 26,390 361,157 48 S. Joseph Fortunato 25,097 367,835 50 Edith E. Holiday 28,650 211,400 24 Frank W.T. LaHaye 26,975 163,753 27 Gordon S. Macklin 26,390 361,157 48 1. For the fiscal year ended February 28, 1999. During the period from March 1, 1998, through May 31, 1998, fees at the rate of $1,300 per month plus $1,300 per board meeting attended were in effect. 2. For the calendar year ended December 31, 1998. 3. We base the number of boards on the number of registered investment companies in the Franklin Templeton Group of Funds. This number does not include the total number of series or funds within each investment company for which the board members are responsible. The Franklin Templeton Group of Funds currently includes 54 registered investment companies, with approximately 163 U.S. based funds or series. Noninterested board members are reimbursed for expenses incurred in connection with attending board meetings, paid pro rata by each fund in the Franklin Templeton Group of Funds for which they serve as director or trustee. No officer or board member received any other compensation, including pension or retirement benefits, directly or indirectly from the fund or other funds in the Franklin Templeton Group of Funds. Certain officers or board members who are shareholders of Franklin Resources, Inc. may be deemed to receive indirect remuneration by virtue of their participation, if any, in the fees paid to its subsidiaries. Board members historically have followed a policy of having substantial investments in one or more of the funds in the Franklin Templeton Group of Funds, as is consistent with their individual financial goals. In February 1998, this policy was formalized through adoption of a requirement that each board member invest one-third of fees received for serving as a director or trustee of a Templeton fund in shares of one or more Templeton funds and one-third of fees received for serving as a director or trustee of a Franklin fund in shares of one or more Franklin funds until the value of such investments equals or exceeds five times the annual fees paid such board member. Investments in the name of family members or entities controlled by a board member constitute fund holdings of such board member for purposes of this policy, and a three year phase-in period applies to such investment requirements for newly elected board members. In implementing such policy, a board member's fund holdings existing on February 27, 1998, are valued as of such date with subsequent investments valued at cost. MANAGEMENT AND OTHER SERVICES - ------------------------------------------------------------------------------- MANAGER AND SERVICES PROVIDED Each fund's manager is Franklin Advisers, Inc. The manager is a wholly owned subsidiary of Franklin Resources, Inc. (Resources), a publicly owned company engaged in the financial services industry through its subsidiaries. Charles B. Johnson and Rupert H. Johnson, Jr. are the principal shareholders of Resources. The manager provides investment research and portfolio management services, and selects the securities for each fund to buy, hold or sell. The manager's extensive research activities include, as appropriate, traveling to meet with issuers and to review project sites. The manager also selects the brokers who execute the funds' portfolio transactions. The manager provides periodic reports to the board, which reviews and supervises the manager's investment activities. To protect the funds, the manager and its officers, directors and employees are covered by fidelity insurance. The manager and its affiliates manage numerous other investment companies and accounts. The manager may give advice and take action with respect to any of the other funds it manages, or for its own account, that may differ from action taken by the manager on behalf of each fund. Similarly, with respect to each fund, the manager is not obligated to recommend, buy or sell, or to refrain from recommending, buying or selling any security that the manager and access persons, as defined by applicable federal securities laws, may buy or sell for its or their own account or for the accounts of any other fund. The manager is not obligated to refrain from investing in securities held by the fund or other funds it manages. Of course, any transactions for the accounts of the manager and other access persons will be made in compliance with the funds' code of ethics. Under the funds' code of ethics, employees of the Franklin Templeton Group who are access persons may engage in personal securities transactions subject to the following general restrictions and procedures: (i) the trade must receive advance clearance from a compliance officer and must be completed by the close of the business day following the day clearance is granted; (ii) copies of all brokerage confirmations and statements must be sent to a compliance officer; (iii) all brokerage accounts must be disclosed on an annual basis; and (iv) access persons involved in preparing and making investment decisions must, in addition to (i), (ii) and (iii) above, file annual reports of their securities holdings each January and inform the compliance officer (or other designated personnel) if they own a security that is being considered for a fund or other client transaction or if they are recommending a security in which they have an ownership interest for purchase or sale by a fund or other client. MANAGEMENT FEES Each fund pays the manager a fee equal to a monthly rate of: o 5/96 of 1% of the value of its net assets up to and including $100 million; and o 1/24 of 1% of the value of its net assets over $100 million up to and including $250 million; and o 9/240 of 1% of the value of its net assets in excess of $250 million. The fee is computed at the close of business on the last business day of each month according to the terms of the management agreement. Each class of a funds' shares pays its proportionate share of the fee. For the last three fiscal years ended February 28, the funds paid the following management fees: MANAGEMENT FEES PAID ($) ------------------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------- Arizona Fund 4,124,084 3,799,811 3,627,685 Colorado Fund 1,615,981 1,432,605 1,259,548 Connecticut Fund 1,313,337 1,126,660 1,012,114 Federal Intermediate Fund 1 901,601 628,115 438,843 High Yield Fund 29,382,074 24,164,691 19,114,157 Indiana Fund 357,518 330,541 311,799 Michigan Fund 2 0 0 0 MANAGEMENT FEES PAID ($) ------------------------------------- 1999 1998 1997 - ------------------------------------------------------------------------------- New Jersey Fund 3,411,855 3,074,915 2,827,318 Oregon Fund 2,429,095 2,119,137 1,964,313 Pennsylvania Fund 3,734,742 3,414,301 3,181,417 Puerto Rico Fund 1,223,542 1,137,320 1,083,818 1. For the fiscal years ended February 28, 1999, 1998 and 1997, management fees before any advance waiver, totaled $959,067, $718,091, and $586,462, respectively. Under an agreement by the manager to limit its fees, the fund paid the management fees shown. 2. For the fiscal years ended February 28, 1999, and 1998, and for the period from July 1, 1996, through February 28, 1997, management fees before any advance waiver, totaled $82,747, $44,302, and $12,802, respectively. Under agreements by the manager to limit its fees, the fund paid the management fees shown. ADMINISTRATOR AND SERVICES PROVIDED Franklin Templeton Services, Inc. (FT Services) has an agreement with the manager to provide certain administrative services and facilities for each fund. FT Services is wholly owned by Resources and is an affiliate of the funds' manager and principal underwriter. The administrative services FT Services provides include preparing and maintaining books, records, and tax and financial reports, and monitoring compliance with regulatory requirements. ADMINISTRATION FEES The manager pays FT Services a monthly fee equal to an annual rate of: o 0.15% of each fund's average daily net assets up to $200 million; o 0.135% of average daily net assets over $200 million up to $700 million; o 0.10% of average daily net assets over $700 million up to $1.2 billion; and o 0.075% of average daily net assets over $1.2 billion. During the last three fiscal years ended February 28, the manager paid FT Services the following administration fees: ADMINISTRATION FEES PAID ($) ------------------------------------ 1999 1998 1997 1 - ------------------------------------------------------------------------------- Arizona Fund 1,132,869 1,060,456 430,330 Colorado Fund 436,830 383,050 144,807 Connecticut Fund 347,940 298,352 114,062 Federal Intermediate Fund 246,943 176,069 62,460 High Yield Fund 5,411,515 4,519,848 1,626,344 Indiana Fund 85,406 79,053 31,765 Michigan Fund 19,373 10,238 2,069 New Jersey Fund 970,458 872,308 339,343 Oregon Fund 679,370 587,736 229,705 Pennsylvania Fund 1,046,296 971,653 384,008 Puerto Rico Fund 325,819 301,686 120,593 1. For the period from October 1, 1996, through February 28, 1997. SHAREHOLDER SERVICING AND TRANSFER AGENT Franklin/ Templeton Investor Services, Inc. (Investor Services) is each fund's shareholder servicing agent and acts as the funds' transfer agent and dividend-paying agent. Investor Services is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Please send all correspondence to Investor Services to P.O. Box 997151, Sacramento, CA 95899-9983. For its services, Investor Services receives a fixed fee per account. Each fund also will reimburse Investor Services for certain out-of-pocket expenses, which may include payments by Investor Services to entities, including affiliated entities, that provide sub-shareholder services, recordkeeping and/or transfer agency services to beneficial owners of the fund. The amount of reimbursements for these services per benefit plan participant fund account per year will not exceed the per account fee payable by the fund to Investor Services in connection with maintaining shareholder accounts. CUSTODIAN Bank of New York, Mutual Funds Division, 90 Washington Street, New York, NY 10286, acts as custodian of each fund's securities and other assets. AUDITOR PricewaterhouseCoopers LLP, 333 Market Street, San Francisco, CA 94105, is the funds' independent auditor. The auditor gives an opinion on the financial statements included in the trust's Annual Report to Shareholders and reviews the trust's registration statement filed with the U.S. Securities and Exchange Commission (SEC). PORTFOLIO TRANSACTIONS - ------------------------------------------------------------------------------- Since most purchases by the funds are principal transactions at net prices, the funds incur little or no brokerage costs. Each fund deals directly with the selling or buying principal or market maker without incurring charges for the services of a broker on its behalf, unless it is determined that a better price or execution may be obtained by using the services of a broker. Purchases of portfolio securities from underwriters will include a commission or concession paid by the issuer to the underwriter, and purchases from dealers will include a spread between the bid and ask prices. As a general rule, the funds do not buy securities in underwritings where they are given no choice, or only limited choice, in the designation of dealers to receive the commission. The funds seek to obtain prompt execution of orders at the most favorable net price. Transactions may be directed to dealers in return for research and statistical information, as well as for special services provided by the dealers in the execution of orders. It is not possible to place a dollar value on the special executions or on the research services the manager receives from dealers effecting transactions in portfolio securities. The allocation of transactions in order to obtain additional research services allows the manager to supplement its own research and analysis activities and to receive the views and information of individuals and research staffs of other securities firms. As long as it is lawful and appropriate to do so, the manager and its affiliates may use this research and data in their investment advisory capacities with other clients. If the funds' officers are satisfied that the best execution is obtained, the sale of fund shares, as well as shares of other funds in the Franklin Templeton Group of Funds, also may be considered a factor in the selection of broker-dealers to execute the funds' portfolio transactions. If purchases or sales of securities of the funds and one or more other investment companies or clients supervised by the manager are considered at or about the same time, transactions in these securities will be allocated among the several investment companies and clients in a manner deemed equitable to all by the manager, taking into account the respective sizes of the funds and the amount of securities to be purchased or sold. In some cases this procedure could have a detrimental effect on the price or volume of the security so far as the funds are concerned. In other cases it is possible that the ability to participate in volume transactions may improve execution and reduce transaction costs to the funds. During the fiscal years ended February 28, 1999, 1998 and 1997, the funds did not pay any brokerage commissions. As of February 28, 1999, the funds did not own securities of their regular broker-dealers. DISTRIBUTIONS AND TAXES - ------------------------------------------------------------------------------- The funds calculate dividends and capital gains the same way for each class. The amount of any income dividends per share will differ, however, generally due to the difference in the distribution and service (Rule 12b-1) fees of each class. The funds do not pay "interest" or guarantee any fixed rate of return on an investment in their shares. DISTRIBUTIONS OF NET INVESTMENT INCOME Each fund receives income generally in the form of interest on its investments. This income, less expenses incurred in the operation of the fund, constitutes the fund's net investment income from which dividends may be paid to you. By meeting certain requirements of the Internal Revenue Code, the funds have qualified and continue to qualify to pay exempt-interest dividends to you. These dividends are derived from interest income exempt from regular federal income tax, and are not subject to regular federal income tax when they are distributed to you. In addition, to the extent that exempt-interest dividends are derived from interest on obligations of a state or its political subdivisions, or from interest on qualifying U.S. territorial obligations (including qualifying obligations of Puerto Rico, the U.S. Virgin Islands or Guam), they also will be exempt from that state's personal income taxes. Most states generally do not grant tax-free treatment to interest on state and municipal securities of other states. The funds may earn taxable income on any temporary investments, on the discount from stripped obligations or their coupons, on income from securities loans or other taxable transactions, or on ordinary income derived from the sale of market discount bonds. Any fund distributions from such income will be taxable to you as ordinary income, whether you receive them in cash or in additional shares. DISTRIBUTIONS OF CAPITAL GAINS The funds may derive capital gains and losses in connection with sales or other dispositions of their portfolio securities. Distributions from net short-term capital gains will be taxable to you as ordinary income. Distributions from net long-term capital gains will be taxable to you as long-term capital gain, regardless of how long you have held your shares in a fund. Any net capital gains realized by a fund generally will be distributed once each year, and may be distributed more frequently, if necessary, in order to reduce or eliminate excise or income taxes on the fund. INFORMATION ON THE TAX CHARACTER OF DISTRIBUTIONS The funds will inform you of the amount of your ordinary income dividends and capital gains distributions at the time they are paid, and will advise you of their tax status for federal income tax purposes shortly after the close of each calendar year, including the portion of the distributions that on average comprise taxable income or interest income that is a tax preference item under the alternative minimum tax. If you have not held fund shares for a full year, a fund may designate and distribute to you, as taxable, tax-exempt or tax preference income, a percentage of income that is not equal to the actual amount of such income earned during the period of your investment in the fund. ELECTION TO BE TAXED AS A REGULATED INVESTMENT COMPANY Each fund has elected to be treated as a regulated investment company under Subchapter M of the Internal Revenue Code, has qualified as such for its most recent fiscal year, and intends to so qualify during the current fiscal year. As regulated investment companies, the funds generally pay no federal income tax on the income and gains they distribute to you. The board reserves the right not to maintain the qualification of a fund as a regulated investment company if it determines such course of action to be beneficial to shareholders. In such case, a fund will be subject to federal, and possibly state, corporate taxes on its taxable income and gains, and distributions to you will be taxed as ordinary dividend income to the extent of the fund's earnings and profits. EXCISE TAX DISTRIBUTION REQUIREMENTS To avoid federal excise taxes, the Internal Revenue Code requires each fund to distribute to you by December 31 of each year, at a minimum, the following amounts: 98% of its taxable ordinary income earned during the calendar year; 98% of its capital gain net income earned during the twelve month period ending October 31; and 100% of any undistributed amounts from the prior year. Each fund intends to declare and pay these amounts in December (or in January that are treated by you as received in December) to avoid these excise taxes, but can give no assurances that its distributions will be sufficient to eliminate all taxes. REDEMPTION OF FUND SHARES Redemptions and exchanges of fund shares are taxable transactions for federal and state income tax purposes. If you redeem your fund shares, or exchange your fund shares for shares of a different Franklin Templeton Fund, the IRS will require that you report a gain or loss on your redemption or exchange. If you hold your shares as a capital asset, the gain or loss that you realize will be capital gain or loss and will be long-term or short-term, generally depending on how long you hold your shares. Any loss incurred on the redemption or exchange of shares held for six months or less will be disallowed to the extent of any exempt-interest dividends distributed to you with respect to your fund shares and any remaining loss will be treated as a long-term capital loss to the extent of any long-term capital gains distributed to you by the fund on those shares. All or a portion of any loss that you realize upon the redemption of your fund shares will be disallowed to the extent that you buy other shares in the fund (through reinvestment of dividends or otherwise) within 30 days before or after your share redemption. Any loss disallowed under these rules will be added to your tax basis in the new shares you buy. DEFERRAL OF BASIS If you redeem some or all of your shares in a fund, and then reinvest the sales proceeds in the fund or in another Franklin Templeton Fund within 90 days of buying the original shares, the sales charge that would otherwise apply to your reinvestment may be reduced or eliminated. The IRS will require you to report gain or loss on the redemption of your original shares in a fund. In doing so, all or a portion of the sales charge that you paid for your original shares in a fund will be excluded from your tax basis in the shares sold (for the purpose of determining gain or loss upon the sale of such shares). The portion of the sales charge excluded will equal the amount that the sales charge is reduced on your reinvestment. Any portion of the sales charge excluded from your tax basis in the shares sold will be added to the tax basis of the shares you acquire from your reinvestment. DIVIDENDS-RECEIVED DEDUCTION FOR CORPORATIONS Because each fund's income consists of interest rather than dividends, no portion of its distributions generally will be eligible for the corporate dividends-received deduction. None of the dividends paid by the funds for the most recent fiscal year qualified for such deduction, and it is anticipated that none of the current year's dividends will so qualify. INVESTMENT IN COMPLEX SECURITIES Each fund may invest in complex securities. These investments may be subject to numerous special and complex tax rules. These rules could affect whether gains and losses recognized by a fund are treated as ordinary income or capital gain, accelerate the recognition of income to a fund and/or defer a fund's ability to recognize losses. In turn, these rules may affect the amount, timing or character of the income distributed to you by a fund. TREATMENT OF PRIVATE ACTIVITY BOND INTEREST Interest on certain private activity bonds, while still exempt from regular federal income tax, is a preference item for taxpayers when determining their alternative minimum tax under the Internal Revenue Code and under the income tax provisions of several states. Private activity bond interest could subject you to or increase your liability under federal and state alternative minimum taxes, depending on your individual or corporate tax position. Persons who are defined in the Internal Revenue Code as substantial users (or persons related to such users) of facilities financed by private activity bonds should consult with their tax advisors before buying fund shares. ORGANIZATION, VOTING RIGHTS AND PRINCIPAL HOLDERS - ------------------------------------------------------------------------------- Each fund is a series of Franklin Tax-Free Trust, an open-end management investment company, commonly called a mutual fund. The trust was organized as a Massachusetts business trust in September 1984, and is registered with the SEC. As a shareholder of a Massachusetts business trust, you could, under certain circumstances, be held personally liable as a partner for its obligations. The Agreement and Declaration of Trust, however, contains an express disclaimer of shareholder liability for acts or obligations of the fund. The Declaration of Trust also provides for indemnification and reimbursement of expenses out of the fund's assets if you are held personally liable for obligations of the fund. The Declaration of Trust provides that the fund shall, upon request, assume the defense of any claim made against you for any act or obligation of the fund and satisfy any judgment thereon. All such rights are limited to the assets of the fund. The Declaration of Trust further provides that the fund may maintain appropriate insurance (for example, fidelity bonding and errors and omissions insurance) for the protection of the fund, its shareholders, trustees, officers, employees and agents to cover possible tort and other liabilities. Furthermore, the activities of the fund as an investment company, as distinguished from an operating company, would not likely give rise to liabilities in excess of the fund's total assets. Thus, the risk that you would incur financial loss on account of shareholder liability is limited to the unlikely circumstance in which both inadequate insurance exists and the fund itself is unable to meet its obligations. The High Yield Fund currently offers three classes of shares, Class A, Class B and Class C. The Arizona, Colorado, Connecticut, New Jersey, Oregon, Pennsylvania, and Puerto Rico Funds currently offer two classes of shares, Class A and Class C. Before January 1, 1999, Class A shares were designated Class I and Class C shares were designated Class II. The High Yield Fund began offering Class B shares on January 1, 1999. The full title of each class is: o Franklin Arizona Tax-Free Income Fund - Class A o Franklin Arizona Tax-Free Income Fund - Class C o Franklin Colorado Tax-Free Income Fund - Class A o Franklin Colorado Tax-Free Income Fund - Class C o Franklin Connecticut Tax-Free Income Fund - Class A o Franklin Connecticut Tax-Free Income Fund - Class C o Franklin High Yield Tax-Free Income Fund - Class A o Franklin High Yield Tax-Free Income Fund - Class B o Franklin High Yield Tax-Free Income Fund - Class C o Franklin New Jersey Tax-Free Income Fund - Class A o Franklin New Jersey Tax-Free Income Fund - Class C o Franklin Oregon Tax-Free Income Fund - Class A o Franklin Oregon Tax-Free Income Fund - Class C o Franklin Pennsylvania Tax-Free Income Fund - Class A o Franklin Pennsylvania Tax-Free Income Fund - Class C o Franklin Puerto Rico Tax-Free Income Fund - Class A o Franklin Puerto Rico Tax-Free Income Fund - Class C The Federal Intermediate, Indiana and Michigan Funds each offer only one share class. Because their sales charge structures and Rule 12b-1 plans are similar to those of Class A shares, shares of these funds are considered Class A shares for redemption, exchange and other purposes. The funds may offer additional classes of shares in the future. Shares of each class represent proportionate interests in the fund's assets. On matters that affect the fund as a whole, each class has the same voting and other rights and preferences as any other class. On matters that affect only one class, only shareholders of that class may vote. Each class votes separately on matters affecting only that class, or expressly required to be voted on separately by state or federal law. Shares of each class of a series have the same voting and other rights and preferences as the other classes and series of the trust for matters that affect the trust as a whole. Additional series may be offered in the future. The trust has noncumulative voting rights. For board member elections, this gives holders of more than 50% of the shares voting the ability to elect all of the members of the board. If this happens, holders of the remaining shares voting will not be able to elect anyone to the board. The trust does not intend to hold annual shareholder meetings. The trust or a series of the trust may hold special meetings, however, for matters requiring shareholder approval. A meeting may be called by the board to consider the removal of a board member if requested in writing by shareholders holding at least 10% of the outstanding shares. In certain circumstances, we are required to help you communicate with other shareholders about the removal of a board member. A special meeting also may be called by the board in its discretion. As of April 12, 1999, the principal shareholders of the funds, beneficial or of record, were: NAME AND ADDRESS SHARE CLASS PERCENTAGE (%) - ------------------------------------------------------------------------------- MICHIGAN FUND Franklin Resources Inc. Class A 16.02 Corporate Accounting 555 Airport Boulevard 4th Fl Burlingame, CA 94010 From time to time, the number of fund shares held in the "street name" accounts of various securities dealers for the benefit of their clients or in centralized securities depositories may exceed 5% of the total shares outstanding. As of April 12, 1999, the officers and board members, as a group, owned of record and beneficially less than 1% of the outstanding shares of each fund and class. The board members may own shares in other funds in the Franklin Templeton Group of Funds. BUYING AND SELLING SHARES - ------------------------------------------------------------------------------- The fund continuously offers its shares through securities dealers who have an agreement with Franklin Templeton Distributors, Inc. (Distributors). A securities dealer includes any financial institution that, either directly or through affiliates, has an agreement with Distributors to handle customer orders and accounts with the fund. This reference is for convenience only and does not indicate a legal conclusion of capacity. Banks and financial institutions that sell shares of the fund may be required by state law to register as securities dealers. For investors outside the U.S., the offering of fund shares may be limited in many jurisdictions. An investor who wishes to buy shares of the fund should determine, or have a broker-dealer determine, the applicable laws and regulations of the relevant jurisdiction. Investors are responsible for compliance with tax, currency exchange or other regulations applicable to redemption and purchase transactions in any jurisdiction to which they may be subject. Investors should consult appropriate tax and legal advisors to obtain information on the rules applicable to these transactions. All checks, drafts, wires and other payment mediums used to buy or sell shares of the fund must be denominated in U.S. dollars. We may, in our sole discretion, either (a) reject any order to buy or sell shares denominated in any other currency or (b) honor the transaction or make adjustments to your account for the transaction as of a date and with a foreign currency exchange factor determined by the drawee bank. When you buy shares, if you submit a check or a draft that is returned unpaid to the fund we may impose a $10 charge against your account for each returned item. INITIAL SALES CHARGES The maximum initial sales charge is 2.25% for the Federal Intermediate Fund. For each of the other funds, the maximum initial sales charge is 4.25% for Class A and 1% for Class C. There is no initial sales charge for Class B shares of the High Yield Fund. The initial sales charge for Class A shares may be reduced for certain large purchases, as described in the prospectus. We offer several ways for you to combine your purchases in the Franklin Templeton Funds to take advantage of the lower sales charges for large purchases. The Franklin Templeton Funds include the U.S. registered mutual funds in the Franklin Group of Funds(R) and the Templeton Group of Funds except Franklin Valuemark Funds, Templeton Capital Accumulator Fund, Inc., and Templeton Variable Products Series Fund. CUMULATIVE QUANTITY DISCOUNT. For purposes of calculating the sales charge on Class A shares, you may combine the amount of your current purchase with the cost or current value, whichever is higher, of your existing shares in the Franklin Templeton Funds. You also may combine the shares of your spouse, children under the age of 21 or grandchildren under the age of 21. If you are the sole owner of a company, you also may add any company accounts, including retirement plan accounts. LETTER OF INTENT (LOI). You may buy Class A shares at a reduced sales charge by completing the letter of intent section of your account application. A letter of intent is a commitment by you to invest a specified dollar amount during a 13 month period. The amount you agree to invest determines the sales charge you pay. By completing the letter of intent section of the application, you acknowledge and agree to the following: o You authorize Distributors to reserve 5% of your total intended purchase in Class A shares registered in your name until you fulfill your LOI. Your periodic statements will include the reserved shares in the total shares you own, and we will pay or reinvest dividend and capital gain distributions on the reserved shares according to the distribution option you have chosen. o You give Distributors a security interest in the reserved shares and appoint Distributors as attorney-in-fact. o Distributors may sell any or all of the reserved shares to cover any additional sales charge if you do not fulfill the terms of the LOI. o Although you may exchange your shares, you may not sell reserved shares until you complete the LOI or pay the higher sales charge. After you file your LOI with the fund, you may buy Class A shares at the sales charge applicable to the amount specified in your LOI. Sales charge reductions based on purchases in more than one Franklin Templeton Fund will be effective only after notification to Distributors that the investment qualifies for a discount. Any Class A purchases you made within 90 days before you filed your LOI also may qualify for a retroactive reduction in the sales charge. If you file your LOI with the fund before a change in the fund's sales charge, you may complete the LOI at the lower of the new sales charge or the sales charge in effect when the LOI was filed. Your holdings in the Franklin Templeton Funds acquired more than 90 days before you filed your LOI will be counted towards the completion of the LOI, but they will not be entitled to a retroactive reduction in the sales charge. Any redemptions you make during the 13 month period will be subtracted from the amount of the purchases for purposes of determining whether the terms of the LOI have been completed. If the terms of your LOI are met, the reserved shares will be deposited to an account in your name or delivered to you or as you direct. If the amount of your total purchases, less redemptions, is more than the amount specified in your LOI and is an amount that would qualify for a further sales charge reduction, a retroactive price adjustment will be made by Distributors and the securities dealer through whom purchases were made. The price adjustment will be made on purchases made within 90 days before and on those made after you filed your LOI and will be applied towards the purchase of additional shares at the offering price applicable to a single purchase or the dollar amount of the total purchases. If the amount of your total purchases, less redemptions, is less than the amount specified in your LOI, the sales charge will be adjusted upward, depending on the actual amount purchased (less redemptions) during the period. You will need to send Distributors an amount equal to the difference in the actual dollar amount of sales charge paid and the amount of sales charge that would have applied to the total purchases if the total of the purchases had been made at one time. Upon payment of this amount, the reserved shares held for your account will be deposited to an account in your name or delivered to you or as you direct. If within 20 days after written request the difference in sales charge is not paid, we will redeem an appropriate number of reserved shares to realize the difference. If you redeem the total amount in your account before you fulfill your LOI, we will deduct the additional sales charge due from the sale proceeds and forward the balance to you. GROUP PURCHASES. If you are a member of a qualified group, you may buy Class A shares at a reduced sales charge that applies to the group as a whole. The sales charge is based on the combined dollar value of the group members' existing investments, plus the amount of the current purchase. A qualified group is one that: o Was formed at least six months ago, o Has a purpose other than buying fund shares at a discount, o Has more than 10 members, o Can arrange for meetings between our representatives and group members, o Agrees to include Franklin Templeton Fund sales and other materials in publications and mailings to its members at reduced or no cost to Distributors, o Agrees to arrange for payroll deduction or other bulk transmission of investments to the fund, and o Meets other uniform criteria that allow Distributors to achieve cost savings in distributing shares. WAIVERS FOR INVESTMENTS FROM CERTAIN PAYMENTS. Class A shares may be purchased without an initial sales charge or contingent deferred sales charge (CDSC) by investors who reinvest within 365 days: o Dividend and capital gain distributions from any Franklin Templeton Fund. The distributions generally must be reinvested in the same share class. Certain exceptions apply, however, to Class C shareholders who chose to reinvest their distributions in Class A shares of the fund before November 17, 1997, and to Advisor Class or Class Z shareholders of a Franklin Templeton Fund who may reinvest their distributions in the fund's Class A shares. This waiver category also applies to Class B and C shares. o Dividend or capital gain distributions from a real estate investment trust (REIT) sponsored or advised by Franklin Properties, Inc. o Annuity payments received under either an annuity option or from death benefit proceeds, if the annuity contract offers as an investment option the Franklin Valuemark Funds or the Templeton Variable Products Series Fund. You should contact your tax advisor for information on any tax consequences that may apply. o Redemption proceeds from a repurchase of shares of Franklin Floating Rate Trust, if the shares were continuously held for at least 12 months. If you immediately placed your redemption proceeds in a Franklin Bank CD or a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date the CD matures, including any rollover, or the date you redeem your money fund shares. o Redemption proceeds from the sale of Class A shares of any of the Templeton Global Strategy Funds if you are a qualified investor. If you paid a CDSC when you redeemed your Class A shares from a Templeton Global Strategy Fund, a new CDSC will apply to your purchase of fund shares and the CDSC holding period will begin again. We will, however, credit your fund account with additional shares based on the CDSC you previously paid and the amount of the redemption proceeds that you reinvest. If you immediately placed your redemption proceeds in a Franklin Templeton money fund, you may reinvest them as described above. The proceeds must be reinvested within 365 days from the date they are redeemed from the money fund. WAIVERS FOR CERTAIN INVESTORS. Class A shares also may be purchased without an initial sales charge or CDSC by various individuals and institutions due to anticipated economies in sales efforts and expenses, including: o Trust companies and bank trust departments agreeing to invest in Franklin Templeton Funds over a 13 month period at least $1 million of assets held in a fiduciary, agency, advisory, custodial or similar capacity and over which the trust companies and bank trust departments or other plan fiduciaries or participants, in the case of certain retirement plans, have full or shared investment discretion. We will accept orders for these accounts by mail accompanied by a check or by telephone or other means of electronic data transfer directly from the bank or trust company, with payment by federal funds received by the close of business on the next business day following the order. o Any state or local government or any instrumentality, department, authority or agency thereof that has determined the fund is a legally permissible investment and that can only buy fund shares without paying sales charges. Please consult your legal and investment advisors to determine if an investment in a fund is permissible and suitable for you and the effect, if any, of payments by the fund on arbitrage rebate calculations. o Broker-dealers, registered investment advisors or certified financial planners who have entered into an agreement with Distributors for clients participating in comprehensive fee programs o Qualified registered investment advisors who buy through a broker-dealer or service agent who has entered into an agreement with Distributors o Registered securities dealers and their affiliates, for their investment accounts only o Current employees of securities dealers and their affiliates and their family members, as allowed by the internal policies of their employer o Officers, trustees, directors and full-time employees of the Franklin Templeton Funds or the Franklin Templeton Group, and their family members, consistent with our then-current policies o Any investor who is currently a Class Z shareholder of Franklin Mutual Series Fund Inc. (Mutual Series), or who is a former Mutual Series Class Z shareholder who had an account in any Mutual Series fund on October 31, 1996, or who sold his or her shares of Mutual Series Class Z within the past 365 days o Investment companies exchanging shares or selling assets pursuant to a merger, acquisition or exchange offer o Accounts managed by the Franklin Templeton Group o Certain unit investment trusts and their holders reinvesting distributions from the trusts SALES IN TAIWAN. Under agreements with certain banks in Taiwan, Republic of China, each fund's shares are available to these banks' trust accounts without a sales charge. The banks may charge service fees to their customers who participate in the trusts. A portion of these service fees may be paid to Distributors or one of its affiliates to help defray expenses of maintaining a service office in Taiwan, including expenses related to local literature fulfillment and communication facilities. Each fund's Class A shares may be offered to investors in Taiwan through securities advisory firms known locally as Securities Investment Consulting Enterprises. In conformity with local business practices in Taiwan, Class A shares may be offered with the following schedule of sales charges: SIZE OF PURCHASE - U.S. DOLLARS SALES CHARGE (%) - ------------------------------------------------------------------------------- Under $30,000 3.0 $30,000 but less than $100,000 2.0 $100,000 but less than $400,000 1.0 $400,000 or more 0 DEALER COMPENSATION Securities dealers may at times receive the entire sales charge. A securities dealer who receives 90% or more of the sales charge may be deemed an underwriter under the Securities Act of 1933, as amended. Financial institutions or their affiliated brokers may receive an agency transaction fee in the percentages indicated in the dealer compensation table in the funds' prospectus. Distributors may pay the following commissions, out of its own resources, to securities dealers who initiate and are responsible for purchases of Class A shares of $1 million or more: 0.75% on sales of $1 million to $2 million, plus 0.60% on sales over $2 million to $3 million, plus 0.50% on sales over $3 million to $50 million, plus 0.25% on sales over $50 million to $100 million, plus 0.15% on sales over $100 million. These breakpoints are reset every 12 months for purposes of additional purchases. Distributors and/or its affiliates provide financial support to various securities dealers that sell shares of the Franklin Templeton Group of Funds. This support is based primarily on the amount of sales of fund shares. The amount of support may be affected by: total sales; net sales; levels of redemptions; the proportion of a securities dealer's sales and marketing efforts in the Franklin Templeton Group of Funds; a securities dealer's support of, and participation in, Distributors' marketing programs; a securities dealer's compensation programs for its registered representatives; and the extent of a securities dealer's marketing programs relating to the Franklin Templeton Group of Funds. Financial support to securities dealers may be made by payments from Distributors' resources, from Distributors' retention of underwriting concessions and, in the case of funds that have Rule 12b-1 plans, from payments to Distributors under such plans. In addition, certain securities dealers may receive brokerage commissions generated by fund portfolio transactions in accordance with the rules of the National Association of Securities Dealers, Inc. Distributors routinely sponsors due diligence meetings for registered representatives during which they receive updates on various Franklin Templeton Funds and are afforded the opportunity to speak with portfolio managers. Invitation to these meetings is not conditioned on selling a specific number of shares. Those who have shown an interest in the Franklin Templeton Funds, however, are more likely to be considered. To the extent permitted by their firm's policies and procedures, registered representatives' expenses in attending these meetings may be covered by Distributors. CONTINGENT DEFERRED SALES CHARGE (CDSC) If you invest $1 million or more in Class A shares, either as a lump sum or through our cumulative quantity discount or letter of intent programs, a CDSC may apply on any shares you sell within 12 months of purchase. For Class C shares, a CDSC may apply if you sell your shares within 18 months of purchase. The CDSC is 1% of the value of the shares sold or the net asset value at the time of purchase, whichever is less. A CDSC will not apply to Class A purchases over $250 million in the High Yield Fund. For Class B shares of the High Yield Fund, there is a CDSC if you sell your shares within six years, as described in the table below. The charge is based on the value of the shares sold or the net asset value at the time of purchase, whichever is less. IF YOU SELL YOUR CLASS B SHARES WITHIN THIS % IS DEDUCTED FROM THIS MANY YEARS AFTER BUYING THEM YOUR PROCEEDS AS A CDSC - ------------------------------------------------------------------------------- 1 Year 4 2 Years 4 3 Years 3 4 Years 3 5 Years 2 6 Years 1 7 Years 0 CDSC WAIVERS. The CDSC for any share class generally will be waived for: o Account fees o Redemptions of Class A shares by investors who purchased $1 million or more without an initial sales charge if the securities dealer of record waived its commission in connection with the purchase o Redemptions by a fund when an account falls below the minimum required account size o Redemptions following the death of the shareholder or beneficial owner o Redemptions through a systematic withdrawal plan set up before February 1, 1995 o Redemptions through a systematic withdrawal plan set up on or after February 1, 1995, up to 1% monthly, 3% quarterly, 6% semiannually or 12% annually of your account's net asset value depending on the frequency of your plan EXCHANGE PRIVILEGE If you request the exchange of the total value of your account, accrued but unpaid income dividends and capital gain distributions will be reinvested in the fund at net asset value on the date of the exchange, and then the entire share balance will be exchanged into the new fund. Backup withholding and information reporting may apply. If a substantial number of shareholders should, within a short period, sell their fund shares under the exchange privilege, the fund might have to sell portfolio securities it might otherwise hold and incur the additional costs related to such transactions. On the other hand, increased use of the exchange privilege may result in periodic large inflows of money. If this occurs, it is each fund's general policy to initially invest this money in short-term, tax-exempt municipal securities, unless it is believed that attractive investment opportunities consistent with the fund's investment goals exist immediately. This money will then be withdrawn from the short-term, tax-exempt municipal securities and invested in portfolio securities in as orderly a manner as is possible when attractive investment opportunities arise. The proceeds from the sale of shares of an investment company are generally not available until the seventh day following the sale. The funds you are seeking to exchange into may delay issuing shares pursuant to an exchange until that seventh day. The sale of fund shares to complete an exchange will be effected at net asset value at the close of business on the day the request for exchange is received in proper form. SYSTEMATIC WITHDRAWAL PLAN Our systematic withdrawal plan allows you to sell your shares and receive regular payments from your account on a monthly, quarterly, semiannual or annual basis. The value of your account must be at least $5,000 and the minimum payment amount for each withdrawal must be at least $50. There are no service charges for establishing or maintaining a systematic withdrawal plan. Once your plan is established, any distributions paid by the fund will be automatically reinvested in your account. Payments under the plan will be made from the redemption of an equivalent amount of shares in your account, generally on the 25th day of the month in which a payment is scheduled. If the 25th falls on a weekend or holiday, we will process the redemption on the next business day. When you sell your shares under a systematic withdrawal plan, it is a taxable transaction. To avoid paying sales charges on money you plan to withdraw within a short period of time, you may not want to set up a systematic withdrawal plan if you plan to buy shares on a regular basis. Shares sold under the plan also may be subject to a CDSC. Redeeming shares through a systematic withdrawal plan may reduce or exhaust the shares in your account if payments exceed distributions received from the fund. This is especially likely to occur if there is a market decline. If a withdrawal amount exceeds the value of your account, your account will be closed and the remaining balance in your account will be sent to you. Because the amount withdrawn under the plan may be more than your actual yield or income, part of the payment may be a return of your investment. You may discontinue a systematic withdrawal plan, change the amount and schedule of withdrawal payments, or suspend one payment by notifying us by mail or by phone at least seven business days before the end of the month preceding a scheduled payment. The fund may discontinue a systematic withdrawal plan by notifying you in writing and will automatically discontinue a systematic withdrawal plan if all shares in your account are withdrawn or if the fund receives notification of the shareholder's death or incapacity. REDEMPTIONS IN KIND Each fund has committed itself to pay in cash (by check) all requests for redemption by any shareholder of record, limited in amount, however, during any 90-day period to the lesser of $250,000 or 1% of the value of the fund's net assets at the beginning of the 90-day period. This commitment is irrevocable without the prior approval of the U.S. Securities and Exchange Commission (SEC). In the case of redemption requests in excess of these amounts, the board reserves the right to make payments in whole or in part in securities or other assets of the fund, in case of an emergency, or if the payment of such a redemption in cash would be detrimental to the existing shareholders of the fund. In these circumstances, the securities distributed would be valued at the price used to compute the fund's net assets and you may incur brokerage fees in converting the securities to cash. Redemptions in kind are taxable transactions. The fund does not intend to redeem illiquid securities in kind. If this happens, however, you may not be able to recover your investment in a timely manner. SHARE CERTIFICATES We will credit your shares to your fund account. We do not issue share certificates unless you specifically request them. This eliminates the costly problem of replacing lost, stolen or destroyed certificates. If a certificate is lost, stolen or destroyed, you may have to pay an insurance premium of up to 2% of the value of the certificate to replace it. Any outstanding share certificates must be returned to the fund if you want to sell or exchange those shares or if you would like to start a systematic withdrawal plan. The certificates should be properly endorsed. You can do this either by signing the back of the certificate or by completing a share assignment form. For your protection, you may prefer to complete a share assignment form and to send the certificate and assignment form in separate envelopes. GENERAL INFORMATION If dividend checks are returned to the fund marked "unable to forward" by the postal service, we will consider this a request by you to change your dividend option to reinvest all distributions. The proceeds will be reinvested in additional shares at net asset value until we receive new instructions. Distribution or redemption checks sent to you do not earn interest or any other income during the time the checks remain uncashed. Neither the funds nor their affiliates will be liable for any loss caused by your failure to cash such checks. The funds are not responsible for tracking down uncashed checks, unless a check is returned as undeliverable. In most cases, if mail is returned as undeliverable we are required to take certain steps to try to find you free of charge. If these attempts are unsuccessful, however, we may deduct the costs of any additional efforts to find you from your account. These costs may include a percentage of the account when a search company charges a percentage fee in exchange for its location services. The wiring of redemption proceeds is a special service that we make available whenever possible. By offering this service to you, the funds are not bound to meet any redemption request in less than the seven day period prescribed by law. Neither the funds nor their agents shall be liable to you or any other person if, for any reason, a redemption request by wire is not processed as described in the prospectus. Franklin Templeton Investor Services, Inc. (Investor Services) may pay certain financial institutions that maintain omnibus accounts with the funds on behalf of numerous beneficial owners for recordkeeping operations performed with respect to such owners. For each beneficial owner in the omnibus account, the fund may reimburse Investor Services an amount not to exceed the per account fee that the fund normally pays Investor Services. These financial institutions also may charge a fee for their services directly to their clients. If you buy or sell shares through your securities dealer, we use the net asset value next calculated after your securities dealer receives your request, which is promptly transmitted to the fund. If you sell shares through your securities dealer, it is your dealer's responsibility to transmit the order to the fund in a timely fashion. Your redemption proceeds will not earn interest between the time we receive the order from your dealer and the time we receive any required documents. Any loss to you resulting from your dealer's failure to transmit your redemption order to the fund in a timely fashion must be settled between you and your securities dealer. Certain shareholder servicing agents may be authorized to accept your transaction request. For institutional accounts, there may be additional methods of buying or selling fund shares than those described in this SAI or in the prospectus. In the event of disputes involving multiple claims of ownership or authority to control your account, the fund has the right (but has no obligation) to: (a) freeze the account and require the written agreement of all persons deemed by the fund to have a potential property interest in the account, before executing instructions regarding the account; (b) interplead disputed funds or accounts with a court of competent jurisdiction; or (c) surrender ownership of all or a portion of the account to the IRS in response to a notice of levy. PRICING SHARES - ------------------------------------------------------------------------------- When you buy shares, you pay the offering price. The offering price is the net asset value (NAV) per share plus any applicable sales charge, calculated to two decimal places using standard rounding criteria. When you sell shares, you receive the NAV minus any applicable CDSC. The value of a mutual fund is determined by deducting the fund's liabilities from the total assets of the portfolio. The net asset value per share is determined by dividing the net asset value of the fund by the number of shares outstanding. Each fund calculates the NAV per share of each class each business day at the close of trading on the New York Stock Exchange (normally 1:00 p.m. pacific time). The funds do not calculate the NAV on days the New York Stock Exchange (NYSE) is closed for trading, which include New Year's Day, Martin Luther King Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day. When determining its NAV, each fund values cash and receivables at their realizable amounts, and records interest as accrued. Each fund values over-the-counter portfolio securities within the range of the most recent quoted bid and ask prices. If portfolio securities trade both in the over-the-counter market and on a stock exchange, each fund values them according to the broadest and most representative market as determined by the manager. Municipal securities generally trade in the over-the-counter market rather than on a securities exchange. In the absence of a sale or reported bid and ask prices, information with respect to bond and note transactions, quotations from bond dealers, market transactions in comparable securities, and various relationships between securities are used to determine the value of municipal securities. Generally, trading in U.S. government securities and money market instruments is substantially completed each day at various times before the close of the NYSE. The value of these securities used in computing the NAV is determined as of such times. Occasionally, events affecting the values of these securities may occur between the times at which they are determined and the close of the NYSE that will not be reflected in the computation of the NAV. If events materially affecting the values of these securities occur during this period, the securities will be valued at their fair value as determined in good faith by the board. Other securities for which market quotations are readily available are valued at the current market price, which may be obtained from a pricing service, based on a variety of factors including recent trades, institutional size trading in similar types of securities (considering yield, risk and maturity) and/or developments related to specific issues. Securities and other assets for which market prices are not readily available are valued at fair value as determined following procedures approved by the board. With the approval of the board, each fund may use a pricing service, bank or securities dealer to perform any of the above described functions. THE UNDERWRITER - ------------------------------------------------------------------------------- Franklin Templeton Distributors, Inc. (Distributors) acts as the principal underwriter in the continuous public offering of each fund's shares. Distributors is located at 777 Mariners Island Blvd., San Mateo, CA 94404. Distributors pays the expenses of the distribution of fund shares, including advertising expenses and the costs of printing sales material and prospectuses used to offer shares to the public. Each fund pays the expenses of preparing and printing amendments to its registration statements and prospectuses (other than those necessitated by the activities of Distributors) and of sending prospectuses to existing shareholders. The table below shows the aggregate underwriting commissions Distributors received in connection with the offering of the funds' shares, the net underwriting discounts and commissions Distributors retained after allowances to dealers, and the amounts Distributors received in connection with redemptions or repurchases of shares for the last three fiscal years ended February 28: AMOUNT RECEIVED IN CONNECTION WITH TOTAL AMOUNT REDEMPTIONS COMMISSIONS RETAINED BY AND RECEIVED DISTRIBUTORS REPURCHASES ($) ($) ($) - ------------------------------------------------------------------------------- 1999 Arizona Fund 3,109,731 204,136 12,269 Colorado Fund 1,230,170 75,655 8,464 Connecticut Fund 1,280,521 72,556 7,518 Federal Intermediate Fund 408,916 55,742 4,464 High Yield Fund 24,360,736 1,514,537 283,409 Indiana Fund 206,649 14,009 - Michigan Fund 208,099 13,810 - New Jersey Fund 2,838,883 169,312 23,450 Oregon Fund 2,294,919 142,478 13,763 Pennsylvania Fund 2,942,369 186,194 16,329 Puerto Rico Fund 703,085 44,229 5,057 1998 Arizona Fund 2,894,958 189,181 5,073 Colorado Fund 1,099,794 68,871 2,658 Connecticut Fund 1,038,873 64,019 2,066 Federal Intermediate Fund 346,839 47,207 - High Yield Fund 27,355,789 1,661,281 114,622 Indiana Fund 188,219 12,470 - Michigan Fund 112,690 7,243 - New Jersey Fund 2,514,214 152,637 10,997 Oregon Fund 1,645,005 106,236 4,656 Pennsylvania Fund 3,017,041 187,577 5,534 Puerto Rico Fund 748,531 49,128 1,587 1997 Arizona Fund 2,438,719 159,341 2,749 Colorado Fund 838,759 52,237 6,126 Connecticut Fund 958,649 60,427 711 Federal Intermediate Fund 301,298 40,297 - High Yield Fund 26,688,526 1,654,304 52,856 Indiana Fund 200,618 13,121 - Michigan Fund 43,942 2,585 - New Jersey Fund 2,075,332 131,524 4,080 Oregon Fund 1,398,757 89,649 2,950 Pennsylvania Fund 2,594,028 155,077 31,296 Puerto Rico Fund 621,195 39,228 2,964 Distributors may be entitled to reimbursement under the Rule 12b-1 plans, as discussed below. Except as noted, Distributors received no other compensation from the fund for acting as underwriter. DISTRIBUTION AND SERVICE (12B-1) FEES Each class has a separate distribution or "Rule 12b-1" plan. Under each plan, the fund shall pay or may reimburse Distributors or others for the expenses of activities that are primarily intended to sell shares of the class. These expenses may include, among others, distribution or service fees paid to securities dealers or others who have executed a servicing agreement with the fund, Distributors or its affiliates; a prorated portion of Distributors' overhead expenses; and the expenses of printing prospectuses and reports used for sales purposes, and preparing and distributing sales literature and advertisements. The distribution and service (12b-1) fees charged to each class are based only on the fees attributable to that particular class. THE CLASS A PLAN. Payments by the fund under the Class A plan may not exceed 0.15 per year for the Michigan Fund (although it is currently only reimbursing up to 0.10%), and 0.10% per year for the remaining funds, of Class A's average daily net assets, payable quarterly. All distribution expenses over this amount will be borne by those who have incurred them. In implementing the Class A plan, the board has determined that the annual fees payable under the plan for each fund, except the Federal Intermediate and Michigan Funds, will be equal to the sum of: (i) the amount obtained by multiplying 0.10% by the average daily net assets represented by the fund's Class A shares that were acquired by investors on or after May 1, 1994, the effective date of the plan (new assets), and (ii) the amount obtained by multiplying 0.05% by the average daily net assets represented by the fund's Class A shares that were acquired before May 1, 1994 (old assets). These fees will be paid to the current securities dealer of record on the account. In addition, until such time as the maximum payment of 0.10% is reached on a yearly basis, up to an additional 0.02% will be paid to Distributors under the plan. When the fund reaches $4 billion in assets, the amount to be paid to Distributors will be reduced from 0.02% to 0.01%. The payments made to Distributors will be used by Distributors to defray other marketing expenses that have been incurred in accordance with the plan, such as advertising. The fee is a Class A expense. This means that all Class A shareholders, regardless of when they purchased their shares, will bear Rule 12b-1 expenses at the same rate. The initial rate for each fund, except the Federal Intermediate and Michigan Funds, will be at least 0.07% (0.05% plus 0.02%) of the average daily net assets of Class A and, as Class A shares are sold on or after May 1, 1994, will increase over time. Thus, as the proportion of Class A shares purchased on or after May 1, 1994, increases in relation to outstanding Class A shares, the expenses attributable to payments under the plan also will increase (but will not exceed 0.10% of average daily net assets). While this is the currently anticipated calculation for fees payable under the Class A plan for each fund, except the Federal Intermediate and Michigan Funds, the plan permits the board to allow such funds to pay a full 0.10% on all assets at any time. The approval of the board would be required to change the calculation of the payments to be made under the Class A plan. The Class A plan for each fund, except the Michigan Fund, does not permit unreimbursed expenses incurred in a particular year to be carried over to or reimbursed in later years. THE CLASS B (HIGH YIELD FUND ONLY) AND C PLANS. Under the Class B and C plans, the fund pays Distributors up to 0.50% per year of the class's average daily net assets, payable monthly for Class B and quarterly for Class C, to pay Distributors or others for providing distribution and related services and bearing certain expenses. All distribution expenses over this amount will be borne by those who have incurred them. The fund also may pay a servicing fee of up to 0.15% per year of the class's average daily net assets, payable monthly for Class B and quarterly for Class C. This fee may be used to pay securities dealers or others for, among other things, helping to establish and maintain customer accounts and records, helping with requests to buy and sell shares, receiving and answering correspondence, monitoring dividend payments from the fund on behalf of customers, and similar servicing and account maintenance activities. The expenses relating to each of the Class B and C plans also are used to pay Distributors for advancing the commission costs to securities dealers with respect to the initial sale of Class B and C shares. Further, the expenses relating to the Class B plan may be used by Distributors to pay third party financing entities that have provided financing to Distributors in connection with advancing commission costs to securities dealers. THE CLASS A, B AND C PLANS. In addition to the payments that Distributors or others are entitled to under each plan, each plan also provides that to the extent the fund, the manager or Distributors or other parties on behalf of the fund, the manager or Distributors make payments that are deemed to be for the financing of any activity primarily intended to result in the sale of fund shares within the context of Rule 12b-1 under the Investment Company Act of 1940, as amended, then such payments shall be deemed to have been made pursuant to the plan. The terms and provisions of each plan relating to required reports, term, and approval are consistent with Rule 12b-1. In no event shall the aggregate asset-based sales charges, which include payments made under each plan, plus any other payments deemed to be made pursuant to a plan, exceed the amount permitted to be paid under the rules of the National Association of Securities Dealers, Inc. To the extent fees are for distribution or marketing functions, as distinguished from administrative servicing or agency transactions, certain banks will not be entitled to participate in the plans as a result of applicable federal law prohibiting certain banks from engaging in the distribution of mutual fund shares. These banking institutions, however, are permitted to receive fees under the plans for administrative servicing or for agency transactions. If you are a customer of a bank that is prohibited from providing these services, you would be permitted to remain a shareholder of a fund, and alternate means for continuing the servicing would be sought. In this event, changes in the services provided might occur and you might no longer be able to avail yourself of any automatic investment or other services then being provided by the bank. It is not expected that you would suffer any adverse financial consequences as a result of any of these changes. Each plan has been approved in accordance with the provisions of Rule 12b-1. The plans are renewable annually by a vote of the board, including a majority vote of the board members who are not interested persons of the fund and who have no direct or indirect financial interest in the operation of the plans, cast in person at a meeting called for that purpose. It is also required that the selection and nomination of such board members be done by the noninterested members of the fund's board. The plans and any related agreement may be terminated at any time, without penalty, by vote of a majority of the noninterested board members on not more than 60 days' written notice, by Distributors on not more than 60 days' written notice, by any act that constitutes an assignment of the management agreement with the manager or by vote of a majority of the outstanding shares of the class. The Federal Intermediate Fund's plan also may be terminated by any act that constitutes an assignment of the underwriting agreement with Distributors. Distributors or any dealer or other firm also may terminate their respective distribution or service agreement at any time upon written notice. The plans and any related agreements may not be amended to increase materially the amount to be spent for distribution expenses without approval by a majority of the outstanding shares of the class, and all material amendments to the plans or any related agreements shall be approved by a vote of the noninterested board members, cast in person at a meeting called for the purpose of voting on any such amendment. Distributors is required to report in writing to the board at least quarterly on the amounts and purpose of any payment made under the plans and any related agreements, as well as to furnish the board with such other information as may reasonably be requested in order to enable the board to make an informed determination of whether the plans should be continued. For the fiscal year ended February 28, 1999, Distributors' eligible expenditures for advertising, printing, and payments to underwriters and broker-dealers pursuant to the plans and the amounts the funds paid Distributors under the plans were: DISTRIBUTORS' AMOUNT PAID ELIGIBLE BY THE EXPENSES ($) FUND ($) - -------------------------------------------------------------------------------- Arizona Fund - Class A 905,874 756,099 Arizona Fund - Class C 228,434 118,919 Colorado Fund - Class A 273,334 206,877 Colorado Fund - Class C 201,435 88,879 Connecticut Fund - Class A 401,801 266,061 Connecticut Fund - Class C 189,417 99,834 Federal Intermediate Fund 302,601 160,061 High Yield Fund - Class A 8,022,234 5,149,820 High Yield Fund - Class B1 167,011 1,654 High Yield Fund - Class C 5,282,583 3,431,976 Indiana Fund - Class A 105,872 50,981 Michigan Fund - Class A 44,118 12,261 New Jersey Fund - Class A 740,497 603,991 New Jersey Fund - Class C 409,626 237,210 Oregon Fund - Class A 589,949 412,566 Oregon Fund - Class C 301,399 154,878 Pennsylvania Fund - Class A 812,111 673,325 Pennsylvania Fund - Class C 345,946 208,598 Puerto Rico Fund - Class A 236,743 192,324 Puerto Rico Fund - Class C 65,212 33,042 1. For the period from January 1, 1999, through February 28, 1999. PERFORMANCE - ------------------------------------------------------------------------------- Performance quotations are subject to SEC rules. These rules require the use of standardized performance quotations or, alternatively, that every non-standardized performance quotation furnished by the fund be accompanied by certain standardized performance information computed as required by the SEC. Average annual total return and current yield quotations used by the fund are based on the standardized methods of computing performance mandated by the SEC. Performance figures reflect Rule 12b-1 fees from the date of the plan's implementation. An explanation of these and other methods used by the funds to compute or express performance follows. Regardless of the method used, past performance does not guarantee future results, and is an indication of the return to shareholders only for the limited historical period used. AVERAGE ANNUAL TOTAL RETURN Average annual total return is determined by finding the average annual rates of return over the periods indicated below that would equate an initial hypothetical $1,000 investment to its ending redeemable value. The calculation assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. The quotation assumes the account was completely redeemed at the end of each period and the deduction of all applicable charges and fees. If a change is made to the sales charge structure, historical performance information will be restated to reflect the maximum initial sales charge currently in effect. When considering the average annual total return quotations you should keep in mind that the maximum initial sales charge reflected in each quotation is a one time fee charged on all direct purchases, which will have its greatest impact during the early stages of your investment. This charge will affect actual performance less the longer you retain your investment in the fund. The average annual total returns for the indicated periods ended February 28, 1999, were: INCEPTION 1 5 10 SINCE DATE YEAR YEARS YEARS INCEPTION - -------------------------------------------------------------------------------- CLASS A Arizona Fund 9/01/87 0.68% 4.99% 7.10% 7.25% Colorado Fund 9/01/87 0.75% 5.18% 7.34% 7.55% Connecticut Fund 10/03/88 1.12% 4.95% 6.74% 6.70% Federal Intermediate Fund 9/21/92 2.80% 5.56% - 6.54% High Yield Fund 3/18/86 -0.23% 6.12% 7.85% 8.06% Indiana Fund 9/01/87 0.74% 4.95% 7.35% 7.58% Michigan Fund 7/01/96 1.63% - - 7.25% New Jersey Fund 5/12/88 1.13% 4.99% 7.12% 7.44% Oregon Fund 9/01/87 0.62% 4.86% 6.86% 6.93% Pennsylvania Fund 12/01/86 0.63% 5.24% 7.27% 6.77% Puerto Rico Fund 4/03/85 1.16% 5.20% 7.12% 7.53% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------------- CLASS C Arizona Fund 2.47% 6.17% Colorado Fund 2.62% 6.62% Connecticut Fund 3.02% 6.40% High Yield Fund 1.67% 7.39% New Jersey Fund 3.06% 6.39% Oregon Fund 2.55% 6.18% Pennsylvania Fund 2.44% 6.39% Puerto Rico Fund 3.04% 6.44% The following SEC formula was used to calculate these figures: n P(1+T) = ERV where: P = a hypothetical initial payment of $1,000 T = average annual total return n = number of years ERV = ending redeemable value of a hypothetical $1,000 payment made at the beginning of each period at the end of each period CUMULATIVE TOTAL RETURN Like average annual total return, cumulative total return assumes the maximum initial sales charge is deducted from the initial $1,000 purchase, and income dividends and capital gain distributions are reinvested at net asset value. Cumulative total return, however, is based on the actual return for a specified period rather than on the average return over the periods indicated above. The cumulative total returns for the indicated periods ended February 28, 1999, were: INCEPTION 1 5 10 SINCE DATE YEAR YEARS YEARS INCEPTION - -------------------------------------------------------------------------------- CLASS A Arizona Fund 9/01/87 0.68% 27.54% 98.62% 123.48% Colorado Fund 9/01/87 0.75% 28.75% 103.11% 130.95% Connecticut Fund 10/03/88 1.12% 26.89% 92.06% 96.28% Federal Intermediate Fund 9/21/92 2.80% 31.04% - 50.36% High Yield Fund 3/18/86 -0.23% 34.59% 112.92% 172.76% Indiana Fund 9/01/87 0.74% 27.30% 103.21% 131.60% Michigan Fund 7/01/96 1.63% - - 20.50% New Jersey Fund 5/12/88 1.13% 27.58% 98.96% 117.04% Oregon Fund 9/01/87 0.62% 26.76% 94.17% 116.08% Pennsylvania Fund 12/01/86 0.63% 29.08% 101.80% 26.78% Puerto Rico Fund 4/03/85 1.16% 28.87% 99.02% 174.61% SINCE INCEPTION 1 YEAR (5/1/95) - -------------------------------------------------------------------------------- CLASS C Arizona Fund 2.47% 25.79% Colorado Fund 2.62% 27.85% Connecticut Fund 3.02% 26.82% High Yield Fund 1.67% 31.40% New Jersey Fund 3.06% 26.77% Oregon Fund 2.55% 25.84% Pennsylvania Fund 2.44% 26.78% Puerto Rico Fund 3.04% 27.02% CURRENT YIELD Current yield shows the income per share earned by a fund. It is calculated by dividing the net investment income per share earned during a 30-day base period by the applicable maximum offering price per share on the last day of the period and annualizing the result. Expenses accrued for the period include any fees charged to all shareholders of the class during the base period. The yields for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - -------------------------------------------------------------------------------- Arizona Fund 3.87% 3.45% Colorado Fund 3.95% 3.53% Connecticut Fund 3.81% 3.38% Federal Intermediate Fund 3.80% - High Yield Fund 4.71% 4.32% Indiana Fund 3.89% - Michigan Fund 4.55% - New Jersey Fund 3.83% 3.40% Oregon Fund 3.86% 3.44% Pennsylvania Fund 4.03% 3.61% Puerto Rico Fund 3.80% 3.37% The following SEC formula was used to calculate these figures: 6 Yield = 2 [(a-b + 1) - 1] --- cd where: a = interest earned during the period b = expenses accrued for the period (net of reimbursements) c = the average daily number of shares outstanding during the period that were entitled to receive dividends d = the maximum offering price per share on the last day of the period TAXABLE-EQUIVALENT YIELD Each fund also may quote a taxable-equivalent yield that shows the before-tax yield that would have to be earned from a taxable investment to equal the yield. Taxable-equivalent yield is computed by dividing the portion of the yield that is tax-exempt by one minus the highest applicable federal or combined federal and state income tax rate and adding the product to the portion of the yield that is not tax-exempt, if any. The taxable-equivalent yields for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ---------------------------------------------------------------------------- Arizona Fund 6.75% 6.01% Colorado Fund 6.88% 6.15% Connecticut Fund 6.61% 5.86% Federal Intermediate Fund 6.29% - High Yield Fund 7.80% 7.15% Indiana Fund 6.74% - Michigan Fund 7.88% - New Jersey Fund 6.77% 6.01% Oregon Fund 7.02% 6.26% Pennsylvania Fund 6.86% 6.15% Puerto Rico Fund 6.29% 5.58% As of February 28, 1999, the federal or combined federal and state income tax rates upon which the taxable-equivalent yield quotations were based were as follows: COMBINED RATE - ------------------------------------------------------------------- Arizona Fund 42.6% Colorado Fund 42.6% Connecticut Fund 42.3% Federal Intermediate Fund 39.6% High Yield Fund 39.6% Indiana Fund 42.3% Michigan Fund 42.3% New Jersey Fund 43.4% Oregon Fund 45.0% Pennsylvania Fund 41.3% Puerto Rico Fund 39.6% From time to time, as any changes to the rates become effective, taxable-equivalent yield quotations advertised by the funds will be updated to reflect these changes. The funds expect updates may be necessary as tax rates are changed by federal and state governments. The advantage of tax-free investments, like the funds, will be enhanced by any tax rate increases. Therefore, the details of specific tax increases may be used in sales material for the funds. CURRENT DISTRIBUTION RATE Current yield and taxable-equivalent yield, which are calculated according to a formula prescribed by the SEC, are not indicative of the amounts which were or will be paid to shareholders. Amounts paid to shareholders are reflected in the quoted current distribution rate or taxable-equivalent distribution rate. The current distribution rate is usually computed by annualizing the dividends paid per share by a class during a certain period and dividing that amount by the current maximum offering price. The current distribution rate differs from the current yield computation because it may include distributions to shareholders from sources other than interest, if any, and is calculated over a different period of time. The current distribution rates for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ---------------------------------------------------------------------- Arizona Fund 4.80% 4.23% Colorado Fund 4.72% 4.30% Connecticut Fund 4.74% 4.33% Federal Intermediate Fund 4.31% - High Yield Fund 5.40% 4.92% Indiana Fund 4.87% - Michigan Fund 4.56% - New Jersey Fund 4.80% 4.38% Oregon Fund 4.71% 4.27% Pennsylvania Fund 4.80% 4.37% Puerto Rico Fund 4.59% 4.18% A taxable-equivalent distribution rate shows the taxable distribution rate equivalent to the current distribution rate. The advertised taxable-equivalent distribution rate will reflect the most current federal and state tax rates available to the fund. The taxable-equivalent distribution rates for the 30-day period ended February 28, 1999, were: CLASS A CLASS C - ---------------------------------------------------------------------- Arizona Fund 8.37% 7.72% Colorado Fund 8.23% 7.49% Connecticut Fund 8.22% 7.51% Federal Intermediate Fund 7.14% - High Yield Fund 8.94% 8.15% Indiana Fund 8.43% - Michigan Fund 7.90% - New Jersey Fund 8.49% 7.75% Oregon Fund 8.57% 7.77% Pennsylvania Fund 8.18% 7.44% Puerto Rico Fund 7.60% 6.92% VOLATILITY Occasionally statistics may be used to show the a fund's volatility or risk. Measures of volatility or risk are generally used to compare a fund's net asset value or performance to a market index. One measure of volatility is beta. Beta is the volatility of a fund relative to the total market, as represented by an index considered representative of the types of securities in which the fund invests. A beta of more than 1.00 indicates volatility greater than the market and a beta of less than 1.00 indicates volatility less than the market. Another measure of volatility or risk is standard deviation. Standard deviation is used to measure variability of net asset value or total return around an average over a specified period of time. The idea is that greater volatility means greater risk undertaken in achieving performance. OTHER PERFORMANCE QUOTATIONS The funds also may quote the performance of shares without a sales charge. Sales literature and advertising may quote a cumulative total return, average annual total return and other measures of performance with the substitution of net asset value for the public offering price. Each fund may include in its advertising or sales material information relating to investment goals and performance results of funds belonging to the Franklin Templeton Group of Funds. Franklin Resources, Inc. is the parent company of the advisors and underwriter of the Franklin Templeton Group of Funds. COMPARISONS To help you better evaluate how an investment in the fund may satisfy your investment goal, advertisements and other materials about the fund may discuss certain measures of fund performance as reported by various financial publications. Materials also may compare performance (as calculated above) to performance as reported by other investments, indices, and averages. These comparisons may include, but are not limited to, the following examples: o Salomon Brothers Broad Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate and mortgage bonds. o Lehman Brothers Aggregate Bond Index or its component indices - measures yield, price and total return for Treasury, agency, corporate, mortgage and Yankee bonds. o Lehman Brothers Municipal Bond Index or its component indices - measures yield, price and total return for the municipal bond market. o Bond Buyer 20 Index - an index of municipal bond yields based upon yields of 20 general obligation bonds maturing in 20 years. o Bond Buyer 40 Index - an index composed of the yield to maturity of 40 bonds. The index attempts to track the new-issue market as closely as possible, so it changes bonds twice a month, adding all new bonds that meet certain requirements and deleting an equivalent number according to their secondary market trading activity. As a result, the average par call date, average maturity date, and average coupon rate can and have changed over time. The average maturity generally has been about 29-30 years. o Financial publications: THE WALL STREET JOURNAL, and BUSINESS WEEK, FINANCIAL WORLD, FORBES, FORTUNE, and MONEY magazines - provide performance statistics over specified time periods. o Salomon Brothers Composite High Yield Index or its component indices - measures yield, price and total return for the Long-Term High-Yield Index, Intermediate-Term High-Yield Index, and Long-Term Utility High-Yield Index. o Historical data supplied by the research departments of CS First Boston Corporation, the J. P. Morgan companies, Salomon Brothers, Merrill Lynch, Lehman Brothers and Bloomberg L.P. o Morningstar - information published by Morningstar, Inc., including Morningstar proprietary mutual fund ratings. The ratings reflect Morningstar's assessment of the historical risk-adjusted performance of a fund over specified time periods relative to other funds within its category. o Lipper - Mutual Fund Performance Analysis and Lipper - Fixed Income Fund Performance Analysis - measure total return and average current yield for the mutual fund industry and rank individual mutual fund performance over specified time periods, assuming reinvestment of all distributions, exclusive of any applicable sales charges. o Savings and Loan Historical Interest Rates - as published in the U.S. Savings & Loan League Fact Book. o Consumer Price Index (or Cost of Living Index), published by the U.S. Bureau of Labor Statistics - a statistical measure of change, over time, in the price of goods and services in major expenditure groups. o CDA Mutual Fund Report, published by CDA Investment Technologies, Inc. - analyzes price, current yield, risk, total return, and average rate of return (average annual compounded growth rate) over specified time periods for the mutual fund industry. o Standard & Poor's Bond Indices - measure yield and price of corporate, municipal, and government bonds. From time to time, advertisements or information for each fund may include a discussion of certain attributes or benefits to be derived from an investment in the fund. The advertisements or information may include symbols, headlines, or other material that highlights or summarizes the information discussed in more detail in the communication. Advertisements or sales material issued by each fund also may discuss or be based upon information in a recent issue of the Special Report on Tax Freedom Day published by the Tax Foundation, a Washington, D.C. based nonprofit research and public education organization. The report illustrates, among other things, the annual amount of time the average taxpayer works to satisfy his or her tax obligations to the federal, state and local taxing authorities. Advertisements or information also may compare each fund's performance to the return on certificates of deposit (CDs) or other investments. You should be aware, however, that an investment in the fund involves the risk of fluctuation of principal value, a risk generally not present in an investment in a CD issued by a bank. For example, as the general level of interest rates rise, the value of the fund's fixed-income investments, as well as the value of its shares that are based upon the value of such portfolio investments, can be expected to decrease. Conversely, when interest rates decrease, the value of the fund's shares can be expected to increase. CDs are frequently insured by an agency of the U.S. government. An investment in a fund is not insured by any federal, state or private entity. In assessing comparisons of performance, you should keep in mind that the composition of the investments in the reported indices and averages is not identical to any fund's portfolio, the indices and averages are generally unmanaged, and the items included in the calculations of the averages may not be identical to the formula used by a fund to calculate its figures. In addition, there can be no assurance that a fund will continue its performance as compared to these other averages. MISCELLANEOUS INFORMATION - ------------------------------------------------------------------------------- The funds may help you achieve various investment goals such as accumulating money for retirement, saving for a down payment on a home, college costs and other long-term goals. The Franklin College Costs Planner may help you in determining how much money must be invested on a monthly basis in order to have a projected amount available in the future to fund a child's college education. (Projected college cost estimates are based upon current costs published by the College Board.) The Franklin Retirement Planning Guide leads you through the steps to start a retirement savings program. Of course, an investment in the funds cannot guarantee that these goals will be met. The funds are members of the Franklin Templeton Group of Funds, one of the largest mutual fund organizations in the U.S., and may be considered in a program for diversification of assets. Founded in 1947, Franklin is one of the oldest mutual fund organizations and now services more than 4 million shareholder accounts. In 1992, Franklin, a leader in managing fixed-income mutual funds and an innovator in creating domestic equity funds, joined forces with Templeton, a pioneer in international investing. The Mutual Series team, known for its value-driven approach to domestic equity investing, became part of the organization four years later. Together, the Franklin Templeton Group has over $227 billion in assets under management for more than 7 million U.S. based mutual fund shareholder and other accounts. The Franklin Templeton Group of Funds offers 113 U.S. based open-end investment companies to the public. Each fund may identify itself by its NASDAQ symbol or CUSIP number. Franklin is a leader in the tax-free mutual fund industry and manages more than $51 billion in municipal security assets for over three quarters of a million investors. According to Research and Ratings Review, Franklin had one of the largest staffs of municipal securities analysts in the industry, as of June 30, 1998. Under current tax laws, municipal securities remain one of the few investments offering the potential for tax-free income. In 1999, taxes could cost almost $47 on every $100 earned from a fully taxable investment (based on the maximum combined 39.6% federal tax rate and the highest state tax rate of 12% for 1999). Franklin tax-free funds, however, offer tax relief through a professionally managed portfolio of tax-free securities selected based on their yield, quality and maturity. An investment in a Franklin tax-free fund can provide you with the potential to earn income free of federal taxes and, depending on the fund, state and local taxes as well, while supporting state and local public projects. Franklin tax-free funds also may provide tax-free compounding, when dividends are reinvested. An investment in Franklin's tax-free funds can grow more rapidly than similar taxable investments. Municipal securities are generally considered to be creditworthy, second in quality only to securities issued or guaranteed by the U.S. government and its agencies. The market price of municipal securities, however, may fluctuate. This fluctuation will have a direct impact on the net asset value of the fund's shares. Currently, there are more mutual funds than there are stocks listed on the New York Stock Exchange. While many of them have similar investment goals, no two are exactly alike. Shares of the funds are generally sold through securities dealers, whose investment representatives are experienced professionals who can offer advice on the type of investments suitable to your unique goals and needs, as well as the risks associated with such investments. The Information Services & Technology division of Franklin Resources, Inc. (Resources) established a Year 2000 Project Team in 1996. This team has already begun making necessary software changes to help the computer systems that service the fund and its shareholders to be Year 2000 compliant. After completing these modifications, comprehensive tests are conducted in one of Resources' U.S. test labs to verify their effectiveness. Resources continues to seek reasonable assurances from all major hardware, software or data-services suppliers that they will be Year 2000 compliant on a timely basis. Resources is also beginning to develop a contingency plan, including identification of those mission critical systems for which it is practical to develop a contingency plan. However, in an operation as complex and geographically distributed as Resources' business, the alternatives to use of normal systems, especially mission critical systems, or supplies of electricity or long distance voice and data lines are limited. DESCRIPTION OF RATINGS - ------------------------------------------------------------------------------- MUNICIPAL BOND RATINGS MOODY'S INVESTORS SERVICE, INC. (MOODY'S) Aaa: Municipal bonds rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt-edged." Interest payments are protected by a large or exceptionally stable margin, and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Aa: Municipal bonds rated Aa are judged to be high quality by all standards. Together with the Aaa group, they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large, fluctuation of protective elements may be of greater amplitude, or there may be other elements present that make the long-term risks appear somewhat larger. A: Municipal bonds rated A possess many favorable investment attributes and are considered upper medium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present that suggest a susceptibility to impairment sometime in the future. Baa: Municipal bonds rated Baa are considered medium-grade obligations. They are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. These bonds lack outstanding investment characteristics and, in fact, have speculative characteristics as well. Ba: Municipal bonds rated Ba are judged to have predominantly speculative elements and their future cannot be considered well assured. Often the protection of interest and principal payments may be very moderate and, thereby, not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. B: Municipal bonds rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Caa: Municipal bonds rated Caa are of poor standing. These issues may be in default or there may be present elements of danger with respect to principal or interest. Ca: Municipal bonds rated Ca represent obligations that are speculative to a high degree. These issues are often in default or have other marked shortcomings. C: Municipal bonds rated C are the lowest-rated class of bonds and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. Con.(-): Municipal bonds for which the security depends upon the completion of some act or the fulfillment of some condition are rated conditionally. These are bonds secured by (a) earnings of projects under construction, (b) earnings of projects unseasoned in operation experience, (c) rentals that begin when facilities are completed, or (d) payments to which some other limiting condition attaches. Parenthetical rating denotes probable credit stature upon the completion of construction or the elimination of the basis of the condition. STANDARD & POOR'S CORPORATION (S&P) AAA: Municipal bonds rated AAA are the highest-grade obligations. They possess the ultimate degree of protection as to principal and interest. In the market, they move with interest rates and, hence, provide the maximum safety on all counts. AA: Municipal bonds rated AA also qualify as high-grade obligations, and in the majority of instances differ from AAA issues only in a small degree. Here, too, prices move with the long-term money market. A: Municipal bonds rated A are regarded as upper medium-grade. They have considerable investment strength but are not entirely free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They predominantly reflect money rates in their market behavior but also, to some extent, economic conditions. BBB: Municipal bonds rated BBB are regarded as having an adequate capacity to pay principal and interest. Whereas they normally exhibit adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay principal and interest for bonds in this category than for bonds in the A category. BB, B, CCC, CC: Municipal bonds rated BB, B, CCC and CC are regarded, on balance, as predominantly speculative with respect to the issuer's capacity to pay interest and repay principal in accordance with the terms of the obligations. BB indicates the lowest degree of speculation and CC the highest degree of speculation. While these bonds will likely have some quality and protective characteristics, they are outweighed by large uncertainties or major risk exposures to adverse conditions. C: This rating is reserved for income bonds on which no interest is being paid. D: Debt rated "D" is in default and payment of interest and/or repayment of principal is in arrears. Plus (+) or minus (-): The ratings from "AA" to "CCC" may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. FITCH INVESTORS SERVICE, INC. (FITCH) AAA: Municipal bonds rated AAA are considered to be investment grade and of the highest credit quality. The obligor has an exceptionally strong ability to pay interest and repay principal that is unlikely to be affected by reasonably foreseeable events. AA: Municipal bonds rated AA are considered to be investment grade and of very high credit quality. The obligor's ability to pay interest and repay principal is very strong although not quite as strong as bonds rated AAA and not significantly vulnerable to foreseeable future developments. A: Municipal bonds rated A are considered to be investment grade and of high credit quality. The obligor's ability to pay interest and repay principal is considered to be strong, but may be more vulnerable to adverse changes in economic conditions and circumstances than bonds with higher ratings. BBB: Municipal bonds rated BBB are considered to be investment grade and of satisfactory credit quality. The obligor's ability to pay interest and repay principal is considered adequate. Adverse changes in economic conditions and circumstances, however, are more likely to have an adverse impact on these bonds, and therefore impair timely payment. The likelihood that the ratings of these bonds will fall below investment grade is higher than for bonds with higher ratings. BB: Municipal bonds rated BB are considered speculative. The obligor's ability to pay interest and repay principal may be affected over time by adverse economic changes. Business and financial alternatives can be identified, however, that could assist the obligor in satisfying its debt service requirements. B: Municipal bonds rated B are considered highly speculative. While bonds in this class are currently meeting debt service requirements, the probability of continued timely payment of principal and interest reflects the obligor's limited margin of safety and the need for reasonable business and economic activity throughout the life of the issue. CCC: Municipal bonds rated CCC have certain identifiable characteristics which, if not remedied, may lead to default. The ability to meet obligations requires an advantageous business and economic environment. CC: Municipal bonds rated CC are minimally protected. Default in payment of interest and/or principal seems probable over time. C: Municipal bonds rated C are in imminent default in the payment of interest or principal. DDD, DD and D: Municipal bonds rated DDD, DD and D are in default on interest and/or principal payments. Such bonds are extremely speculative and should be valued on the basis of their ultimate recovery value in liquidation or reorganization of the obligor. DDD represents the highest potential for recovery while D represents the lowest potential for recovery. Plus (+) or minus (-) signs are used with a rating symbol to indicate the relative position of a credit within the rating category. Plus or minus signs are not used with the AAA, DDD, DD or D categories. MUNICIPAL NOTE RATINGS MOODY'S Moody's ratings for state, municipal and other short-term obligations will be designated Moody's Investment Grade (MIG). This distinction is in recognition of the differences between short-term credit risk and long-term risk. Factors affecting the liquidity of the borrower are uppermost in importance in short-term borrowing; factors of the first importance in long-term borrowing risk are of lesser importance in the short run. Symbols used will be as follows: MIG 1: Notes are of the best quality enjoying strong protection from established cash flows of funds for their servicing or from established and broad-based access to the market for refinancing, or both. MIG 2: Notes are of high quality, with margins of protection ample, although not so large as in the preceding group. MIG 3: Notes are of favorable quality, with all security elements accounted for, but lacking the undeniable strength of the preceding grades. Market access for refinancing, in particular, is likely to be less well established. MIG 4: Notes are of adequate quality, carrying specific risk but having protection and not distinctly or predominantly speculative. S&P Until June 29, 1984, S&P used the same rating symbols for notes and bonds. After June 29, 1984, for new municipal note issues due in three years or less, the ratings below will usually be assigned. Notes maturing beyond three years will most likely receive a bond rating of the type recited above. SP-1: Issues carrying this designation have a very strong or strong capacity to pay principal and interest. Issues determined to possess overwhelming safety characteristics will be given a "plus" (+) designation. SP-2: Issues carrying this designation have a satisfactory capacity to pay principal and interest. COMMERCIAL PAPER RATINGS MOODY'S Moody's short-term debt ratings are opinions of the ability of issuers to repay punctually senior debt obligations. These obligations have an original maturity not exceeding one year, unless explicitly noted. Moody's commercial paper ratings, which are also applicable to municipal paper investments, are opinions of the ability of issuers to repay punctually their promissory obligations not having an original maturity in excess of nine months. Moody's employs the following designations for both short-term debt and commercial paper, all judged to be investment grade, to indicate the relative repayment capacity of rated issuers: P-1 (Prime-1): Superior capacity for repayment. P-2 (Prime-2): Strong capacity for repayment. S&P S&P's ratings are a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Ratings are graded into four categories, ranging from "A" for the highest quality obligations to "D" for the lowest. Issues within the "A" category are delineated with the numbers 1, 2 and 3 to indicate the relative degree of safety, as follows: A-1: This designation indicates the degree of safety regarding timely payment is very strong. A "plus" (+) designation indicates an even stronger likelihood of timely payment. A-2: Capacity for timely payment on issues with this designation is strong. The relative degree of safety, however, is not as overwhelming as for issues designated A-1. A-3: Issues carrying this designation have a satisfactory capacity for timely payment. They are, however, somewhat more vulnerable to the adverse effects of changes in circumstances than obligations carrying the higher designations. FITCH Fitch's short-term ratings apply to debt obligations that are payable on demand or have original maturities of generally up to three years, including commercial paper, certificates of deposit, medium-term notes, and municipal and investment notes. The short-term rating places greater emphasis than a long-term rating on the existence of liquidity necessary to meet the issuer's obligations in a timely manner. F-1+: Exceptionally strong credit quality. Regarded as having the strongest degree of assurance for timely payment. F-1: Very strong credit quality. Reflect an assurance of timely payment only slightly less in degree than issues rated F-1+. F-2: Good credit quality. A satisfactory degree of assurance for timely payment, but the margin of safety is not as great as for issues assigned F-1+ and F-1 ratings. F-3: Fair credit quality. Have characteristics suggesting that the degree of assurance for timely payment is adequate; however, near-term adverse changes could cause these securities to be rated below investment grade. F-5: Weak credit quality. Have characteristics suggesting a minimal degree of assurance for timely payment and are vulnerable to near-term adverse changes in financial and economic conditions. D: Default. Actual or imminent payment default. LOC: The symbol LOC indicates that the rating is based on a letter of credit issued by a commercial bank. STATE TAX TREATMENT - ------------------------------------------------------------------------------- The following information on the state income tax treatment of dividends from the funds is based upon correspondence and sources believed to be reliable. Except where otherwise noted, the information pertains to individual state income taxation only. You may be subject to local taxes on dividends or the value of your shares. Corporations, trusts, estates and other entities may be subject to other taxes and should consult with their tax advisors or their state department of revenue. For some investors, a portion of the dividend income may be subject to the federal and/or state alternative minimum tax. ARIZONA Section 43-1021(4) and 43-1121(3) of the Arizona Income Tax Code states that interest on obligations of the state of Arizona or its political subdivisions is exempt from personal and corporate income tax. Sections 43-1022(6) and 43-1122(6) provide similar tax-exempt treatment for interest on obligations of the U.S. or its territories (including Puerto Rico, Guam and the Virgin Islands). Pursuant to State Income Tax Ruling Number 84-10-5, Arizona does not tax dividend income from regulated investment companies, such as the Arizona Fund, to the extent that such income is derived from such exempt obligations. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gain earned by the fund are included in each shareholder's Arizona taxable income as dividend income and long-term capital gain, respectively, and are taxed at ordinary income tax rates. COLORADO SECTIONS 39-22-104 and 39-22-304 of the Colorado Revised Statutes state that interest on obligations of the state of Colorado or its political subdivisions and direct obligations of the U.S. or its possessions is exempt from personal and corporate income tax. The Colorado Department of Revenue has advised in published guidance that distributions from a regulated investment company, such as the Colorado Fund, also will be exempt from personal and corporate income tax if the fund invests in such exempt obligations. The Colorado Department of Revenue has confirmed in guidance dated September 1993 that this exclusion also applies to territorial obligations of the U.S. (including Puerto Rico, Guam and the Virgin Islands). Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations of other states and their political subdivisions do not qualify for this exemption. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of capital gains earned by the fund are included in each shareholder's Colorado taxable income as dividend income and capital gain, respectively, and are taxed at ordinary income tax rates. CONNECTICUT Section 12-701(a)(20) of the Connecticut General Statutes states that interest income from obligations issued by or on behalf of the state of Connecticut, its political subdivisions, public instrumentalities, state or local authorities, districts, or similar public entities created under the laws of the state of Connecticut and exempt obligations of the U.S. or its territories (including Puerto Rico, Guam and the Virgin Islands) is exempt from state personal income tax. Dividends paid by a regulated investment company, such as the Connecticut Fund, that are derived from such exempt obligations will be exempt from state personal income tax, subject to the limitation below for exempt federal obligations. Corporate shareholders generally are subject to Connecticut corporation income taxes on distributions from the fund. Sections 12-701(a)(20) and 12-718 of the Connecticut General Statutes also states that a fund is qualified to pay exempt dividends derived from exempt U.S. government obligations to its shareholders if, at the close of each quarter of its taxable year, at least 50% of the value of its total assets consists of exempt U.S. government obligations. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations of other states and their political subdivisions do not qualify for this exemption. Any distribution of capital gains earned by the fund that are attributable to Connecticut obligations are exempt from Connecticut's individual income tax. All other distributions of capital gains earned by the fund are included in each shareholder's Connecticut taxable income as dividend income and capital gain, respectively, and are taxed at ordinary income rates. INDIANA Corporate taxpayers may be subject to several overlapping Indiana income taxes on income derived from sources within Indiana. Generally, corporations are subject to the higher of the adjusted gross income tax or the gross income tax, plus a supplemental net income tax. Individuals, estates and trusts resident in Indiana generally are subject only to the adjusted gross income tax. Gross Income Tax: Information Bulletins 19 and 79 issued by the Indiana Department of Revenue provide that the proportionate share of dividends received from a regulated investment company, such as the Indiana Fund, derived from investments in direct obligations of the U.S. or its possessions (including Puerto Rico, Guam and the Virgin Islands), will be exempt from the Indiana Gross Income Tax. An exemption also is provided under Indiana law for exempt interest dividends derived from interest on obligations of the state of Indiana or its political subdivisions. Adjusted Gross Income Tax: All of the obligations referred to in the foregoing Bulletins are exempt from the Indiana Adjusted Gross Income Tax. For all taxpayers, dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) will be taxable on a pro rata basis. The fund will file all appropriate certification documents with the Indiana Department of Revenue indicating the exempt portion of distributions to shareholders. Any distributions of net short-term and net long-term capital gain earned by the fund are included in the shareholder's Indiana taxable income as dividend income and long-term capital gain, respectively, and are taxed at ordinary income tax rates. MICHIGAN Section 206.30(1) of the Michigan Compiled Laws generally provides that taxable income, for purposes of the Michigan individual income tax, is determined by reference to federal adjusted gross income, with certain modifications. Interest and dividends derived from obligations or securities of states other than Michigan (less related expenses) must be added back in determining Michigan taxable income. Interest and dividends derived from obligations or securities of Michigan (and its political subdivisions) are exempt and are not, therefore, added back in determining Michigan taxable income. Further, income derived from obligations of the U.S. government that the state is prohibited by law from subjecting to a net income tax is subtracted in determining Michigan taxable income. This includes direct obligations of the U.S. government, its agencies, instrumentalities, or possessions (including Puerto Rico, Guam and the Virgin Islands). Revenue Administrative Bulletin 1986-3 states that a regulated investment company, such as the Michigan Fund, which invests in tax-free municipal obligations of the state of Michigan and its political and governmental subdivisions is permitted to pass-through the exemption of such interest to its shareholders to the extent that such interest qualifies as an exempt-interest dividend of a regulated investment company. The exempt nature of interest from obligations of the U.S. and its territories and possessions also may be passed through to shareholders. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or other obligations from other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gains earned by the fund generally will be included in each shareholder's Michigan taxable income as dividend income and long-term capital gain, respectively, and taxed at ordinary income tax rates. NEW JERSEY Section 54A:6-14.1 of the New Jersey Statutes provides that distributions paid by qualified investment funds, such as the New Jersey Fund, are not included in gross income for purposes of the New Jersey gross income tax to the extent the distributions are attributable to interest or gain from obligations issued by or on behalf of the state of New Jersey or its political subdivisions, or obligations free from state or local taxation by any act of the state of New Jersey or laws of the U.S. (including obligations of the District of Columbia, Puerto Rico, Guam and the Virgin Islands). Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations of other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of net short-term and net long-term capital gain earned by the fund from taxable obligations are included in each shareholder's New Jersey taxable income as dividend income and long-term capital gain, respectively, and are taxed at ordinary income tax rates. OREGON Sections 316.683 and 316-680 of the Oregon Revised Statutes and Oregon Administrative Rule Section 150-316.680-(B) provide that "state exempt-interest dividends" that are paid by a regulated investment company, such as the Oregon Fund, and designated by it as such in a written notice mailed to its shareholders not later than 60 days after the close of its taxable year will be excluded from the shareholders' income for purposes of Oregon's personal income tax. "State exempt-interest dividends" include distributions of interest attributable both to obligations of the state of Oregon and its political subdivisions and to obligations of the U.S., its territories (including Puerto Rico, Guam and the Virgin Islands) and possessions of any U.S. authority, commission or instrumentality. Corporate shareholders generally are subject to the Oregon corporation excise and income tax on distributions from the fund. Dividends paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations of other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Any distributions of capital gain earned by the fund are included in each shareholder's Oregon taxable income as dividend income and capital gain, respectively, and are taxed at ordinary income tax rates. However, a shareholder may defer gain on the sale or other disposition of a capital asset by reinvesting in a qualified investment fund within six months. PENNSYLVANIA Sections 301 and 303 of the Tax Reform Code of Pennsylvania states that interest income derived from obligations that are statutorily free from state or local taxation under the laws of the Commonwealth of Pennsylvania or under the laws of the U.S. is exempt from state personal income tax. Such exempt obligations include obligations issued by the Commonwealth of Pennsylvania, any public authority, commission, board or other state agency, any political subdivision of the state or its public authority, and exempt obligations of the U.S. or its territories (including Puerto Rico, Guam and the Virgin Islands). Sections 301 and 303 of the Code of Pennsylvania states that interest derived by an investment trust, such as the Pennsylvania Fund, from such exempt obligations is not subject to state, personal or corporate net income tax. Fund distributions and the value of fund shares, however, generally are included in the tax base in determining the corporation capital stock or foreign franchise tax. Distributions paid from interest earned on indirect U.S. government obligations (GNMAs, FNMAs, etc.) or obligations of other states and their political subdivisions are fully taxable. To the extent that such taxable investments are made by the fund for temporary or defensive purposes, the distributions will be taxable. Distributions paid by the fund also are generally exempt from the Philadelphia School District Investment Income Tax. Any distributions of net short-term and long-term capital gain earned by the fund are included in each shareholder's Pennsylvania taxable income and are taxed at ordinary income tax rates. Shareholders of the fund who are subject to the Pennsylvania personal property tax in their county of residence will be exempt from county personal property tax to the extent that the portfolio of the fund consists of exempt obligations described above on the annual assessment date of January 1. Information regarding the portion of the value of the shares, if any, which is subject to the Pennsylvania personal property tax will be provided to shareholders of the fund. PUERTO RICO For U.S. citizens and residents, exempt-interest dividends received from the Puerto Rico Fund generally are exempt from U.S. federal and state personal income taxation in all states that impose an income tax, pursuant to section 103 of the Internal Revenue Code and 31 U.S.C. section 3124. For Puerto Rico taxpayers, exempt-interest dividends, to the extent derived from Puerto Rico, Guam and Virgin Island obligations, generally will be exempt from Puerto Rico taxation pursuant to a ruling received by the fund dated May 24, 1996. -----END PRIVACY-ENHANCED MESSAGE-----