"He [Penev] knows the players very well and I think he is the best choice from among the coaches we could have picked," BFU president Borislav Mihaylov told a news conference.
Penev, 45, led Litex Lovech to the Bulgarian league title last season but left them last week. He succeeds German Lothar Matthaus, whose contract was not renewed following Bulgaria's dismal Euro 2012 qualifying campaign.
"I'm honored to lead the national team," said Penev, who will be in charge for the duration of the 2014 World Cup qualifiers and his contract could be extended for two more years.
"This is a step forward in my coaching career," added Penev, who will make his debut in the friendly game against Hungary on February 29. "I believe we have good players and we can achieve something significant."
Penev, capped 62 times by the Balkan country, will have the tough task of piloting Bulgaria through a World Cup qualifying group that contains Italy, Denmark, Czech Republic, Armenia and Malta.
Matthaus became the first foreigner to coach Bulgaria since 1966 when he replaced Stanimir Stoilov in September 2010 but achieved little success and was criticised for not understanding the mentality of Bulgarian football.
Bulgaria finished bottom of Euro 2012 qualifying Group G with only five points from eight matches. They also failed to score in their four home games - their worst ever performance in major tournament qualifying.
Former CSKA Sofia coach Penev was once described by former England coach Terry Venables as "one of the top three forwards in the world," boasting a remarkable scoring record in Spain where he netted more than 150 goals for Valencia, Atletico Madrid, Compostela and Celta Vigo.
He is remembered in Spain for his poacher's instinct in the penalty box and for guiding Atletico to a domestic double in 1996 with the Bulgarian scoring 32 goals in 44 games that season.
