Dear Shareholder:

The 12 months ended March 31, 2018, benefited from mostly upbeat economic data as the US job market continued to improve and the unemployment rate declined. Accordingly, the US Federal Reserve (Fed), under new chairman Jerome Powell, increased its target for the federal funds rate a quarter point from a range of 1.25% to 1.50% to a range of 1.50% to 1.75% at its recent March meeting. This was the Fed’s third rate hike for the 12 months, following June and December.

During the 12 months, the municipal bond market posted modest performance similar to other US fixed income classes, with generally higher returns for longer term and lower rated municipal bonds. Factors contributing to this positive investment environment for municipals included consistently low inflation, stagnant wage growth and international political concerns. Federal government fiscal reform uncertainty also benefited tax-free municipals during most of the period, despite some volatility in reaction to the government’s tax code efforts.

Franklin California Tax-Free Income Fund’s annual report includes more detail about municipal bond market conditions

and a discussion from the portfolio managers. In addition, on our website, franklintempleton.com, you can find updated commentary by our municipal bond experts. Municipal bonds can provide tax-free income and diversification from equities. Despite periods of volatility, municipal bonds historically have had a solid long-term record of performance, driven mostly by their compounding income component. Please remember all securities markets fluctuate, as do mutual fund share prices.

As always, we recommend investors consult their financial advisors to help them make the best decisions for the long term. In a constantly changing market environment, we remain committed to our disciplined strategy as we manage the Fund, keeping in mind the trust you have placed in us. We appreciate your confidence in us and encourage you to contact us when you have questions about your Franklin Templeton tax-free investment.

 

Sincerely,

 

Rupert H. Johnson, Jr.

Chairman

Franklin California Tax-Free Income Fund

 

Sheila Amoroso

 

Rafael R. Costas Jr.

Senior Vice Presidents and Co-Directors

Franklin Municipal Bond Department

This letter reflects our analysis and opinions as of March 31, 2018, unless otherwise indicated. The information is not a complete analysis of every aspect of any market, state, industry, security or fund. Statements of fact are from sources considered reliable.

 

 

Contents

 

Annual Report
Franklin California Tax-Free Income Fund			3
Performance Summary			7
Your Fund’s Expenses			11
Financial Highlights and Statement of Investments			12
Financial Statements			38
Notes to Financial Statements			42
Report of Independent Registered Public Accounting Firm			50
Tax Information			51
Special Meeting of Shareholders			52
Board Members and Officers			54
Shareholder Information			59

 

 

Visit franklintempleton.com for fund updates, to access your account, or to find helpful financial planning tools.

 

This annual report for Franklin California Tax-Free Income Fund covers the fiscal year ended March 31, 2018.

Your Fund’s Goal and Main Investments

The Fund seeks to provide as high a level of income exempt from federal and California personal income taxes (for California residents) as is consistent with prudent investment management and preservation of capital by investing at least 80% of its total assets in securities that pay interest free from such taxes.¹

Performance Overview

The Fund’s Class A share price, as measured by net asset value, decreased from $7.38 on March 31, 2017, to $7.31 on March 31, 2018. The Fund’s Class A shares paid dividends totaling 26.57 cents per share for the reporting period.² The Performance Summary beginning on page 7 shows that at the end of this reporting period the Fund’s Class A shares’ distribution rate was 3.40% based on an annualization of March’s 2.16 cent per share dividend and the maximum offering price of $7.63 on March 31, 2018. An investor in the 2018 maximum combined effective federal and California personal income tax bracket of 53.10% (including 3.8% Medicare tax) would need to earn a distribution rate of 7.25% from a taxable investment to match the Fund’s Class A tax-free distribution rate. For other performance data, please see the Performance Summary. During the period under review, the Fund experienced a reduction of its monthly dividend. While there are many factors that can impact a Funds’ ability to distribute dividends, the primary reason for the dividend cut was due to bonds maturing or being called away by issuers, which were purchased by the Fund at yields greater than the prevailing market yields.

Performance data represent past performance, which does not guarantee future results. Investment return and principal value will fluctuate, and you may have a gain or loss when you sell your shares. Current performance may differ from figures

Credit Quality Composition*

3/31/18

 

Ratings		% of Total Investments
AAA		11.41%
AA		47.67%
A		12.31%
BBB		16.14%
Below Investment Grade		1.08%
Refunded		9.70%
Not Rated		1.69%

*Securities, except for those labeled Not Rated, are assigned ratings by one or more Nationally Recognized Statistical Credit Rating Organizations (NRSROs), such as Standard & Poor’s, Moody’s and Fitch, that can be considered by the investment manager as part of its independent securities analysis. When ratings from multiple agencies are available, the highest is used, consistent with the portfolio investment process. Ratings reflect an NRSRO’s opinion of an issuer’s creditworthiness and typically range from AAA (highest) to D (lowest). The Below Investment Grade category consists of bonds rated below BBB-. The Refunded category generally consists of refunded bonds secured by US government or other high-quality securities and not rerated by an NRSRO. The Not Rated category consists of ratable securities that have not been rated by an NRSRO. Cash and equivalents are excluded from this composition.

shown. For most recent month-end performance, go to franklintempleton.com or call (800) 342-5236.

Municipal Bond Market Overview

The municipal bond market outperformed the US Treasury market but underperformed US stock markets during the 12-month period ended March 31, 2018. Investment-grade municipal bonds, as measured by the Bloomberg Barclays Municipal Bond Index, generated a +2.66% total return for the period, while US Treasuries, as measured by the Bloomberg Barclays US Treasury Index, posted a +0.43% total return.³ Both high-yield corporate bonds and high-yield municipal bonds outperformed their investment-grade counterparts. US stocks, as represented by the Standard & Poor’s^® 500 Index, outperformed both municipals and US Treasuries with a +13.99% total return for the reporting period.³ US stocks

 

generated strong returns through the first ten months of the reporting period, but experienced a significant bout of volatility in early February that led to losses in that month and reduced overall returns. Multiple factors, including recent indications of rising interest rates and proposed steel and aluminum tariffs, contributed to the volatility in stock markets and also drove losses in both the municipal bond market and US Treasury market during the first quarter of 2018.

Municipal issuance during the reporting period totaled $407 billion, a modest 7% decline from total issuance in the previous 12-month period ended March 31, 2017.⁴ Impending tax reform contained potential implications for the municipal bond market and caused a deluge of supply in December, as issuers rushed to market before the end of the 2017. December supply of $63 billion and fourth-quarter 2017 supply of $145 billion eclipsed previous monthly and quarterly records of municipal bond issuance, respectively.⁴ Despite this extraordinary supply pressuring the market, strong demand buoyed returns through the end of 2017. However, diminished issuance ($62 billion in the first quarter of 2018, a 32% decline from the first quarter in 2017),⁴ heavy dealer inventories and selling pressures in 2018 led municipals to have a -1.11% total return during the first quarter of 2018, as measured by the Bloomberg Barclays Municipal Bond Index.³ Municipal performance was in line with US Treasuries, which had a total return of -1.18% during the same period.³

After accounting for redemptions (bonds that matured or were called out of the market), net issuance stood at $64 billion in 2017, which marked a third consecutive year of positive net issuance.⁵ Net issuance turned negative in the first three months of 2018, standing at -$19 billion at period-end.⁵ According to the Investment Company Institute, municipal bond funds reported inflows for 10 of the 12 months of the reporting period, with the only negative flows occurring in December 2017 and February 2018. The total inflows for the period were approximately $30 billion.⁶

The Federal Reserve (Fed) raised its target range for the federal funds rate 0.25% at its December 2017 meeting and another 0.25% at its March 2018 meeting. The target range stood at 1.50%–1.75% at period-end. The Fed also increased the discount rate 0.25% to 2.00% in December and another 0.25% at the March 2018 meeting, to finish the period at 2.25%. The Fed cited a strengthening economic outlook and strong labor

4. Source: The Bond Buyer, Thomson Reuters.

5. Source: Barclays Municipal Credit Research.

6. Source: Investment Company Institute.

Portfolio Composition
3/31/18
		% of Total Investments*
Transportation			22.53	%
General Obligation			18.23	%
Refunded**			17.25	%
Utilities			13.05	%
Hospital & Health Care			9.99	%
Subject to Government Appropriations			6.79	%
Higher Education			6.39	%
Tax-Supported			3.47	%
Other Revenue			1.76	%
Housing			0.54	%

*Does not include cash and cash equivalents.

**Includes all refunded bonds; the percentage may differ from that in the Credit Quality Composition.

market conditions in its press release following the March, 2018 decision. In total, the Fed raised the target range three times in 2017 (March, June, and December), and once so far in 2018.

On February 27, 2018, Jerome Powell spoke before Congress for the first time as Fed Chair after succeeding Janet Yellen in that role. In his prepared remarks, Powell noted an economic backdrop of solid growth and a strong labor market. He reiterated the Fed’s intention to gradually raise interest rates in an effort to keep the economy from overheating while still fostering a return of inflation to the Fed’s 2% target.

Investors continued to favor risky assets through most of the period. Municipal bonds with longer maturities generally performed better than bonds with shorter maturities, and high yield tax-exempt bonds outperformed their investment-grade counterparts. During the 12-month reporting period, the Bloomberg Barclays High Yield Municipal Bond Index generated a +6.03% total return and the Bloomberg Barclays Municipal Long Bond (22+ Years) Index returned +4.68%.³

Several developments affected Puerto Rico bonds over the reporting period. Please visit franklintempleton.com/investor/products/fund-resources/puerto-rico for the latest Puerto Rico updates from Franklin Templeton.

At period-end, we maintained our positive view of the municipal bond market. We believe municipal bonds continue to be an attractive asset class among fixed income securities,

 

and we intend to follow our solid discipline of investing to maximize income, while seeking value in the municipal bond market.

State Update

California’s large and diverse economy continued to expand during the 12 months under review. Universities and innovative businesses supported the state’s expansion. Job growth in the state outpaced that of the nation’s. Unemployment decreased from 4.9% in March 2017 to 4.3% at period-end, yet remained above the 4.1% national rate.⁷

Enactment of California’s fiscal year 2018 budget extended the state’s recent track record of balanced fiscal operations. Highlights of the budget were increased spending for general fund expenditures, education, Medi-Cal funding and pension contributions, all of which are included in the fiscal year 2019 budget proposal unveiled in January 2018. Additionally, California approved legislation raising taxes on motor fuel and vehicle registrations. California’s revenues have increased and the state continued to make deposits to its budget stabilization account, resulting in large budget reserves.

California’s net tax-supported debt was $2,217 per capita and 4.2% of personal income, compared with the $1,006 and 2.5% national medians, respectively.⁸ During the period under review, independent credit rating agency Standard & Poor’s (S&P) assigned California’s general obligations bonds a rating of AA- with a stable outlook.⁹ The rating reflected S&P’s view on the state’s expanding economy, increasing budgetary reserve levels, strong overall liquidity and declining debt ratios. In contrast, S&P cited several challenges to the state, including high housing costs, a volatile revenue structure, retirement benefit liabilities and a large backlog of deferred maintenance and infrastructure needs. Nevertheless, the stable outlook reflected S&P’s view that California has brought its finances into structural alignment.

Investment Strategy

We use a consistent, disciplined strategy in an effort to maximize tax-exempt income for our shareholders, while balancing risk and return within the Fund’s range of allowable investments. We generally employ a buy-and-hold approach and invest in securities we believe should provide the most relative value in the market. We do not use leverage or

Dividend Distributions*

4/1/17–3/31/18

 

						Dividend per Share (cents)
Month		Class A				Class M**				Class C				Class R6***				Advisor Class
April			2.26				—				1.92				—				2.31
May			2.26				—				1.92				—				2.31
June			2.26				—				1.91				—				2.31
July			2.26				—				1.91				—				2.31
August			2.26				—				1.91				—				2.31
Sep- tember			2.21				—				1.86				2.28				2.27
October			2.21				—				1.86				2.28				2.27
November			2.21				—				1.86				2.28				2.27
December			2.16				—				1.81				2.22				2.21
January			2.16				—				1.81				2.22				2.21
February			2.16				2.21				1.81				2.22				2.21
March			2.16				2.21				1.82				2.21				2.21
Total			26.57				4.42				22.40				15.71				27.20

*The distribution amount is the sum of all net investment income distributions for the period shown. All Fund distributions will vary depending upon current market conditions, and past distributions are not indicative of future trends.

**Effective 1/25/18, the Fund began offering Class M shares. See the prospectus for details.

***Effective 8/1/17, the Fund began offering Class R6 shares. See the prospectus for details.

derivatives, nor do we use hedging techniques that could add volatility and contribute to underperformance in adverse markets.

Manager’s Discussion

Based on the combination of our value-oriented philosophy of investing primarily for income and a positive-sloping municipal yield curve, we favored the use of longer term bonds. Consistent with our strategy, we sought to purchase bonds that ranged from 15 to 30 years in maturity with good call features. We believe our conservative, buy-and-hold investment strategy can help us achieve high, current, tax-free income for shareholders.

The Fund holds a very small portion of its assets in Puerto Rico bonds, which decreased in price over the period. Puerto Rico and its municipal issuers continue to experience significant financial difficulties and we continue to monitor developments affecting them.

 

Thank you for your continued participation in Franklin California Tax-Free Income Fund. We look forward to serving your future investment needs.

The foregoing information reflects our analysis, opinions and portfolio holdings as of March 31, 2018, the end of the reporting period. The way we implement our main investment strategies and the resulting portfolio holdings may change depending on factors such as market and economic conditions. These opinions may not be relied upon as investment advice or an offer for a particular security. The information is not a complete analysis of every aspect of any market, state, industry, security or the Fund. Statements of fact are from sources considered reliable, but the investment manager makes no representation or warranty as to their completeness or accuracy. Although historical performance is no guarantee of future results, these insights may help you understand our investment management philosophy.