Federated Investors Inc. (FII), the third-largest manager of money-market funds, said regulators shouldn't prohibit such funds from holding illiquid, or second-tier, securities.

The Pittsburgh-based asset manager also said that ending the standard practice of offering money-market shares at a stable net asset value would be "antithetical" to the goal of making the funds more resilient to certain short-term market risks and safer for investors.

Still, Federated said the funds should be prepared to process transactions at a price less than the $1 when necessary.

Federated, which manages $312.8 billion in money-market fund assets, made its comments in a letter to the Securities and Exchange Commission, which has proposed reforms to the $3.5 trillion money-market fund industry.

The SEC has proposed limiting money-market funds to investing in only the highest-quality securities. Most funds are now permitted to invest up to 5% in second-tier securities.

"Federated strongly believes that the commission should continue to allow investment companies to hold second-tier securities," according to the 36-page letter signed by John McGonigle, executive vice president and chief legal officer at Federated.

Money-market fund investments in second-tier securities reduce concentration in the financial sector; provide greater credit diversification of investments, particularly for tax-exempt funds; and provide a more affordable means of financing issuers of second-tier securities, the letter argued.

Debbie Cunningham, chief investment officer for taxable money-market funds at Federated, noted in an interview that none of these second-tier issuers have defaulted in the recent downturn. "These issuers have held their own," she said.

Fidelity Investments has also opposed the elimination of second-tier securities from money-market portfolios.

Federated also opposes the SEC's proposed ban on illiquid securities.

"Federated believes that the proposed reforms go too far in restricting 'illiquid' securities, both in terms of the definition of a 'liquid' security and in prohibiting their acquisition," McGonigle wrote. "Given the current size of money funds, where 1% of any type of money funds represents several billion dollars, the SEC might reasonably conclude that the money funds can support innovation with a limit below 10% for illiquid securities."

Federated recommended that the SEC not reduce the limit on illiquid securities below 5%.

Said Cunningham, "Although it's not a huge slice of any money-market portfolio, we do think that it offers a little bit of innovation...that allows the marketplace to expand..."

Taxable money-market funds now use asset-backed commercial paper as a liquid asset, and tax-free funds use tender option bonds, she noted. Both asset classes started out as illiquid securities, but have grown into sectors that are very prevalent and key in money-market portfolios, Cunningham said.

Federated suggested changing the definition of a liquid security from one "that can be sold or disposed of in the ordinary course of business within seven days at approximately the value ascribed to it by the money-market fund" to one "that can be sold or disposed of in the ordinary course of business within seven calendar days at approximately its amortized cost."

Many in the industry say a floating net asset value - that is, one that can "break the buck" and drop below the customary $1 per share value - would threaten the viability of money-market funds. Federated agreed that prohibiting money funds from offering shares at a stable NAV would expose investors to market risks. But it supported requiring a money fund to have the capacity to convert to a fluctuating NAV if it can't maintain a stable NAV, provided there is an extended transition period.

"As with the ability to suspend redemptions, it is critical that a board have this alternative available to it in the event of a crisis affecting a money fund's ability to maintain a stable NAV," the letter said.

Cunningham said that when Reserve Primary Fund's NAV fell, problems were added because of the system's inability to operate with a NAV of less than $1.

Federated has confirmed that the processing systems used by its money funds can handle share transactions at a fluctuating NAV, but said many intermediaries who process such transactions can't, and that it will be expensive for them to reprogram their systems. As a result, it encouraged the SEC to provide a long transition period - at least a year - to comply with such a requirement.

The asset manager also said it analyzed the impact of the SEC's proposed reforms on a prime money-market fund's seven-day yield, and found that the proposals would subtract as much as 24 basis points. With the changes Federated has proposed, the fund's yield would be reduced by only 6 basis points, it said.

-By Daisy Maxey, Dow Jones Newswires; 212-416-2237; daisy.maxey@dowjones.com