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Fixed income investors are beset with a host of problems – potential inflation from rising food and materials prices, a gigantic federal budget deficit in the United States, worries about municipal credit quality, and expectations of tighter fiscal policy in 2012.

One solution to the problem? Diversification.

For those invested primarily or exclusively in U.S. fixed income funds, there is now a wide array of global bond funds that help to spread the risk.

There are now about 50 distinct global bond funds that invest in global fixed-income markets, delivering an average annual return of 5.44% over the past five years, compared with about 4.43% for U.S. bond funds, according to Lipper data.

Foreign bond markets provide diversification on an issuer and interest rate environment basis, and funds that do not hedge their foreign currency exposure also provide currency diversification.

To identify the most attractive global bond funds, we looked for funds that have a high ranking from Standard & Poor’s, a strong long-term performance record compared with similar funds, moderate costs, and strong geographic diversification. We excluded institutional shares and funds that are closed to new investors.

Three funds stood out from the rest as being worthy of further consideration.

Among global bond funds, the clear leader is the Templeton Global Bond Fund, which mostly invests in foreign government and government agency securities, and the only five star-ranked fund in that style.

It was opened in 1986, one of the first three to launch, and its massive $46 billion in assets, according to company data, make it far larger than any other.

It also owns the best performance record over the past three and five year periods, and its costs (including a 4.25% front-end load) are in line with its peers.

As of year end 2010, this fund had only 185 holdings, while many funds had double, triple, or even more diversification. Its top 10 holdings accounted for 26.7% of its assets.

Geographically, 42% of the fund’s assets were invested in Asia as of year end 2010, and 30% in Europe and Africa. On a currency basis, however, 59% of the fund is held in North American currencies.

Its average duration was fairly short, at 2.4 years and its 30-day SEC yield of 3.4% was about average for the group.

The AllianceBernstein Global Bond Fund earns mention for its four-star rank, its strong five-year performance, moderate costs, and well-diversified portfolio.

The fund has the fourth best five-year return and the fifth best three-year return and its costs, including its sales load, are below many of its peers. Its 364 holdings, according to Lipper data, as of year end 2010 were more than its highly-ranked peers and its geographic diversity compared favorably to other similar funds with more than half of its assets outside the U.S. 

Many of these funds, particularly the top performers, charge an upfront load.

One that doesn’t, and has low expenses generally, is the Payden Global Fixed Income Fund. While its performance has not matched the other two funds, its annual expense ratio is the lowest of all global income funds.

As of year end, it had just 30% of its assets in U.S. securities. Its average duration of 5.7 years – according to company data – was in line with peers though its 202 holdings is fairly low. It keeps its currency exposure mostly hedged to reduce volatility.