When looking for higher yield or to diversify investments far afield, Canadians investors should look at emerging market (EM) debt.

Sergei Strigo, head of emerging market debt and currency at Amundi Asset Management, says there are three reasons: “Strong economic fundamentals in those markets; attractive valuations, despite a substantial rally last year; and strong inflows into the emerging market fixed-income asset class. Last year was the record year with $90 billion of inflows in EM fixed income.”

But billions worth of capital left fixed income for equities during the second half of 2012 in what’s known as the Great Rotation. How can debt compete with equity?

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Strigo, who also co-manages Excel EM High Income Fund, says “it’s difficult to say which will outperform. But for the majority of investors, both institutional and retail, you can’t have 100% in equities.”

Not only is it not prudent fund management, but also laws and securities regulations mandate institutional investors hold the majority of their assets in fixed income, adds Strigo.

“These kinds of investments can’t be reallocated,” he says. “When I pitch debt, I don’t say move money out of equities; the call is, emerging market debt must play a bigger role within the fixed-income component of the portfolio.”

Although it depends on the risk characteristics of individual investors, Strigo says an emerging market debt allocation of up to 10% of the entire portfolio is healthy. It can go higher depending on the risk characteristics of individual investors.

Much of it comes at the expense of developed market debt.

“The debt of emerging countries is much healthier (below 40% debt-to-GDP) than that of the developed world (above 100% in most countries),” says Strigo. “Generally, it’s safer to invest in emerging countries.”

Further, the developed world is trapped in a low-interest-rate environment, leading to “zero, even negative, yield in some of the short-dated money market instruments in some European countries.”

Against that backdrop, says Strigo, 4.5% to 6% yield in emerging market fixed income clearly makes sense.

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Picking the right emerging market remains key to his strategy which favours local currency bonds in Mexico, Brazil and Chile. In eastern Europe, Russia and Turkey are his favorites. In Asia, where the local bond yields are quite low, he likes the currency play more.

“This is the region with the highest growth forecast for this year,” he says. “Currencies like the Chinese yuan, Korean won and the Malaysian ringgit have a high potential for appreciation.”

However, detractors often point to the issues of liquidity and size. Strigo lets the numbers speak for themselves.

“[According to recent JPMorgan data] the size of investable assets in EM fixed income is over $10 trillion,” he says. “In terms of liquidity, I haven’t seen that many problems; the [U.S.-dollar-denominated] corporate bond market just reached $1 trillion last year.”

This is particularly positive for those emerging countries that are issuing U.S. dollar-denominated debt.

“Some new countries that have previously not issued bonds, including in Africa and Latin America, are issuing debt in U.S. dollars,” says Strigo. “You have to remember this is a growing investment area. One of the areas with the largest growth potential remains EM Corporate bond space.”

With the removal of tail risks from the Eurozone and the U.S., this year could be quite profitable for all risky assets, including EM debt, he adds.

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