In the first quarter of 2026, the Franklin Municipal Enhanced Income Separately Managed Account (SMA) navigated a complex market landscape shaped by geopolitical events and evolving economic conditions. This period was characterized by significant shifts in financial market sentiment, initially triggered by escalating tensions in the Middle East. These events led to a traditional risk-off reaction across various asset classes, influencing portfolio positioning and overall performance. The fund's strategic allocations and security selections played a crucial role in its outcomes during this dynamic quarter.

The global financial markets in early 2026 were notably influenced by geopolitical developments, particularly the conflict in the Middle East. This situation prompted investors to de-risk their portfolios, seeking safe-haven assets and leading to increased volatility. Despite these broader market trends, specific sectors within the municipal bond market demonstrated varied resilience. The fund's investment philosophy, centered on meticulous security selection and quality allocation, aimed to capitalize on opportunities while mitigating risks in this challenging environment. Portfolio adjustments were made in response to market signals and credit quality assessments, reflecting a proactive management approach.

During the first quarter, the Franklin Municipal Enhanced Income SMA experienced an underperformance relative to its benchmark, the Bloomberg Municipal Bond Index. The composite returned -0.66% net of fees, while the benchmark registered -0.18%. This disparity was primarily attributable to specific sector and quality allocations. The fund's decision to overweight AAA-rated bonds, combined with strong security selection within the consumer non-cyclicals sector, provided a positive contribution to relative performance. However, underperformance was observed in allocations to banking and capital goods sectors, as well as in certain A+ rated issues. The strategic absence of exposure to BBB-rated bonds also contributed positively to the fund's relative standing, underscoring the importance of credit quality in navigating market uncertainties.

Looking ahead to the remainder of 2026, the municipal bond market faces both challenges and opportunities. The expectation of historically high bond supply suggests a need for robust demand to absorb new issuances. Concurrently, slower economic growth could impose constraints on municipal revenues. Nevertheless, many municipalities benefit from healthy rainy-day funds, which are anticipated to provide a buffer against economic downturns and support fiscal resilience. These factors will continue to inform the fund's investment strategy, focusing on identifying high-quality bonds and sectors with strong fundamental support, while carefully monitoring broader economic and geopolitical trends to adjust the portfolio dynamically.

In summary, the first quarter of 2026 presented a challenging yet dynamic environment for municipal bond investments. Geopolitical tensions initiated a risk-off sentiment, impacting market performance. The Franklin Municipal Enhanced Income SMA's performance reflected the nuances of its sector and quality allocations, with notable contributions from AAA-rated bonds and consumer non-cyclicals, while banking and capital goods sectors posed challenges. The strategic avoidance of lower-rated bonds proved beneficial. Moving forward, the fund will continue to prioritize diligent security selection and adapt its strategy to address the complexities of high bond supply and varying economic conditions, leveraging the fiscal strength of municipalities to achieve its investment objectives.