SHANGHAI/SINGAPORE, Aug 18 (Reuters) - Chinese investors are flocking to bond funds amid signs China's economy is losing steam, causing a growing number of fund managers to restrict purchases to protect existing investors.

The strong demand for bonds has driven yields on China's 10-year treasury to 2.56%, the lowest level since May 2020, after the central bank unexpectedly cut key policy rates on Tuesday to aid recovery.

"Investors would prefer bond funds in a gloomy economy," said Ivan Shi, head of research at Shanghai-based fund consultancy Z-Ben Advisors. "The restrictions on subscriptions are triggered by heavy inflows."

Asset under management (AUM) of bond funds, which are generally considered safer than equities, in June hit the highest level since last October, data from the Asset Management Association of China showed.

This influx of funds potentially dilutes the proceeds of existing fund holders and complicates fund managers' asset allocation.

Avic Fund Management Co said on Friday it has suspended purchases of its AVIC RuiSu Pure Bond Fund, to "protect existing fund holders' interests".

BOC International (China) Co also stopped investors from buying into the BOC International AnChe Bond Fund on Friday, citing the same reason.

Earlier in the week, more than a dozen mutual fund managers including Xingyin Fund Co, Caitong Fund Management Co and Huatai-PineBridge Investments had either halted, or put restrictions, on the purchase of their bond products.

Risk appetite was dented as the latest economic indicators showed China's recovery is missing expectations, while default risks at some leading property developers and missed payments by a major Chinese asset manager are stoking contagion fears in the country's financial system.

China's CSI Ordinary Bond Fund Index has risen 2.8% so far this year, outperforming the stock benchmark , which has dropped more than 2%.

"Such products have delivered solid returns so far this year on the back of a bond bull market fueled by ample liquidity," Shi said.

To bolster the world's second-largest economy, the central bank lowered the medium-term policy rate and signalled more easing in its second-quarter monetary policy report.

"Long-term bond yields probably have a little further to fall as the PBOC continues to ease to support the economy," said Capital Economics in a note. "We forecast the 10-year Chinese government bond yield to fall to 2.4% by end-2023."

(Reporting by Jason Xue in Shanghai and Tom Westbrook in Singapore; Editing by Sharon Singleton)