High yields, improving credit quality and sound balance sheets-what's not to like about emerging markets in today's world?

This is not a sudden development. It was 12 years in the making. In the aftermath of the 1998 Asian currency crisis, the governments in many emerging markets adopted more conventional economic policies designed to keep inflation in check. The result was rapid economic growth, driven at first by exports to the developed world and, later, by domestic consumer demand from a growing middle class.

Meanwhile, the United States and Europe went on an unsustainable credit binge whose legacy has saddled them with massive fiscal deficits and bloated public debt.

The numbers illustrate the stark contrast between these two worlds. While emerging economies' debt-to-Gross Domestic Product ratio averages about 40%, developed nations are at 80% to 120%. "The relative credit quality of the emerging markets will continue to improve over the next three years," says David Robbins, portfolio manager of the $441 million TCW Emerging Markets Income Fund. "In this low interest rate environment, money is looking for yield and growth. It will find its way to emerging markets debt and equity."

Emerging markets have arrived, as illustrated by the fact that the biggest debate among experts today is not whether these investments make for good buying opportunities, but rather, whether to buy in local currencies or dollar-denominated bonds.

To that end, Robbins prefers local currency to dollar-denominated issues, as he feels most local currencies will continue to strengthen as the economies deliver superior economic performance. He also favors emerging markets corporate debt (65% to 70% of his fund's assets today) over sovereign debt, which offers less of a premium over the developed market equivalent.

As for the economies' strength, he notes that the emerging markets have surged ahead on one important gauge. They have become bigger consumers while the developed world has had to curb consumption and cut leverage while rebuilding savings.

Those robust macroeconomic fundamentals also appeal to Claire Husson-Citanna, an emerging markets debt portfolio manager and analyst at the $167 million Franklin Templeton Emerging Markets Debt Opportunity Fund. So robust, in fact, that she sees many central banks in emerging economies poised to raise interest rates to tamp down inflationary pressures-a move that could hurt bond prices.

The fund is now focused on short duration government bonds and floating-rate notes in countries like Mexico and Brazil as well as corporate credits that have room for spreads to tighten. "Certain bonds [in Kazakhstan] rebounded strongly from the fall 2008 lows, despite the devaluation of the tenge [the Kazakh currency] in February 2009," Husson-Citanna says. "For instance, bonds issued by Halyk Savings Bank of Kazakhstan, the second largest savings institution, have contributed to our performance."

A Franklin Templeton analysis shows that the dollar-denominated emerging markets sovereign debt exhibits lower volatility (2.3%) than local currency debt (7.5%), local currencies (6.1%) or equities (21%).

As a result, those investors who believe in the fundamental emerging markets story, but are still worried about the risk, especially with equities, may feel more comfortable with debt. "If you already allocate to emerging markets, switching some of your exposure from equities to debt should translate into lower volatility for the portfolio," Husson-Citanna says.

Overall, emerging markets are still regarded as more risky than the developed world, of course. Valuations took a pounding during the financial crisis. The market reaction did not reflect the underlying economic performance, however. "These countries, particularly Asia and Latin America, were last in, first out of the crisis," says Matthew Ryan, portfolio manager of the $2.4 billion MFS Emerging Markets Debt Fund. "They just passed the mother and father of all stress tests."

A strong macroeconomic environment has fostered the private sector in the emerging markets and helped create world-class companies in many countries.

Ryan likes corporate credits but he is also a fan of quasi-sovereign credits-companies like Pemex, the Mexican oil company; Gazprom in Russia; Petronas in Indonesia and Petrobras in Brazil-that are either owned or backed by the government. "Right now, we find better risk reward in quasi-sovereign and corporate opportunities than in sovereign names, where spreads have compressed to very tight levels," Ryan says.

The best performing emerging markets debt funds tend not to track the weighting of benchmark JPMorgan Emerging Markets Bond Index too closely. The index does not include either the corporate credits or local currency bonds that offer the best bets in today's market. "These other asset classes are a good source of alpha, and it's a way to diversify the fund as well as increase the absolute return," Ryan says. He has been buying dollar-denominated quasi-sovereign credits in Asia and Latin America-Petrotrin, which is Trinidad and Tobago's oil company, for example-but has scaled back dollar sovereign credits in Brazil, Peru, Panama and Mexico where he sees little scope for further gains.