News and analysis from Standard & Poor’s MarketScope Advisor

More than $16 billion has flowed into bond mutual funds each and every month since the start of 2009, with a massive $47.7 billion arriving in September alone. At the same time, inflows and outflows for equity funds have stayed roughly equal, meaning no net inflows, even though the Standard & Poor’s 500 was up 23% for the year.

Much of the money is flowing into bond funds with the highest yields, either “junk” bond funds or foreign market bond funds. For the week ending March 10, 2010, emerging market bond funds brought in more than $1 billion in new assets, according to a Reuters report citing data from fund flow tracking firm EPFR Global, the highest weekly total since it started keeping records.

Even Greece, which was forced to pull a bond sale in February due to a collapse in investor confidence, found a very different situation a week later when it offered twice the yield available from German government bonds; it received bids to lend three times the five billion euros it wanted to borrow.

For those willing to lend their money to, say, European governments, Australian television networks, Air Jamaica, or the national oil company of Kazakhstan, international bond funds are a popular place to be. They offer an escape from the “exceptionally low” interest rate environment now being maintained by the Federal Reserve in the United States, and funds that hold bonds denominated in foreign currencies provide a hedge against a declining U.S. dollar.

To identify attractive foreign bond funds, we screened for funds with at least $20 million in assets, open to new investors, with no sales load, and an annual expense ratio of less than 1%. Among that group of about 17 funds, we choose three that had above average performance over the past one- and three-year periods and a ranking of at least three stars from S&P, which uses a five-star system to rank funds (five being highest).

(A note: Standard & Poor’s Mutual Fund Methodology has moved from the industry standard for ranking funds based solely on backward-looking risk-adjusted performance to a more holistic approach, which incorporates a holding-based analysis that includes performance, risk, and cost factors.)

Fidelity’s New Markets Income Fund (FNMIX *****) earns a mention for its low costs and extremely strong track record. As of the end of February 2010, the $3.1 billion fund had a blistering one-year total return of 46.2%, above its peer average of 38.23% for the same period. Over the past three years, its 7.8% average annualized return easily beat its peer average of 5.54%. Its annual turnover rate is pleasingly low at 59% compared with a peer average of 107%, and its 30-day SEC yield is an impressive 6.1% compared with 4.82% for peers.

Such strong performance didn’t happen without the fund taking risks. More than 40% of the fund’s portfolio holdings carry no credit rating at all, according to Lipper data, and of the issues that are rated, none are higher than BBB. Top holdings at the end of January included sovereign debt issued by Russia, Argentina, Mexico, Venezuela, Indonesia, and the Ivory Coast. The fund’s duration of 5.99 years is slightly higher than the peer average of 5.82, making it somewhat more vulnerable if interest rates start rising.

The T. Rowe Price Emerging Markets Bond Fund (PREMX ****) takes much the same approach, posting strong returns on a portfolio of unrated or low-rated bonds. Less than 3% of its holdings are rated above BBB, and unrated issues account for more than 40% of its portfolio, according to Lipper. So far, it’s hard to argue with that strategy: the $2 billion fund had a one -year total return of 38.8% as of the end of February 2010, and an average annualized gain of 5.8% over three years, both above peer averages. Its top 10 holdings comprise government debt issued by Brazil, Iraq, Serbia, Russia, Turkey, and Mexico, as well as bonds issued by the national oil company of Venezuela. Its duration is higher than the Fidelity fund, at 6.63 years, and its 30-day SEC yield is 6.13%. Portfolio turnover is a relatively low 57%.

The Loomis Sayles Global Bond Fund (LSGLX ***) takes a different approach. It takes substantially less risk, holding a portfolio of much higher-quality credits: more than 30% of its bonds have a AAA rating, with another 15% rated either AA or A. Still, about 26% of its bonds are unrated as well. Because of investors’ recent appetite for risk, the fund’s short-term performance has lagged the other two funds substantially, with a one-year return of 28.6%, but its three-year return of 6.2% compares relatively well.

This $2 billion fund takes more than half its holdings from issuers in the United States or Germany, with only about 2% from emerging markets as of the end of February. Its top 10 holdings are made up of government debt issued by Germany, Denmark, Canada, the United States, and Japan, as well as Dublin-based DEPFA Bank. Unlike the other two, most of its portfolio is in non dollar-denominated securities. Its 30-day SEC yield is considerably lower, at 2.87%, though its duration is similar at 5.62 years. Turnover is relatively high, at 75% annually.