Emerging market debt ended 2012 as the world’s best-performing asset class and ongoing hunger for yield creates “a compelling outlook for 2013” according to Western Asset, a subsidiary of Legg Mason.

“With global central banks committed to keeping interest rates low, increased demand for higher yielding assets has pushed record levels of capital into emerging market debt, driving sovereign and corporate yields toward historic lows,” Robert Abad, an emerging markets portfolio manager at Western Asset, said in a statement.

Against this backdrop, Abad highlights the growing high yield emerging market sector, which includes corporate borrowers as well as lower-rated sovereigns such as Argentina, Ukraine and Venezuela, and frontier markets including Sri Lanka, Mongolia and Belize. He observes that the rapid expansion of the asset class over the past few years has occurred as traditional drivers of returns - external sovereign spread compression and rallying US Treasury yields - have largely run their course.

On the sovereign side, Abad says emerging market high yield offers an opportunity to “play the improvement story from the beginning,” with significant capital gains available as frontier markets move up to emerging status. From a valuation perspective, Abad says investors can get higher yields and significant spread pick-up via higher-quality emerging market high-yield corporates versus lower-rated US equivalents.

Sounding a note of caution, Abad says that strong global liquidity conditions have played a critical role in the trajectory of emerging markets over the past decade, allowing sovereigns and companies unfettered access to low-cost capital. He warns that investors should not fall into the trap of assuming emerging market high yield functions like a faster-growth version of the more mature US market.

Without restraint, he says, investors “risk chasing yield into a reversal in global liquidity.” Despite this, Abad believes the asset class should continue to benefit from growing recognition that balance sheet strength and policy flexibility in emerging markets will be more supportive of debt than equities.