BEIJING/SHANGHAI, Feb 23 (Reuters) -

Foreign investors raised their holdings of China's onshore yuan bonds for the fifth straight month in January, lured by the return after factoring in hedging costs.

Foreign institutions held 3.87 trillion yuan ($537.66 billion) in bonds traded on China's interbank market as of the end of January, the central bank's Shanghai head office said on Friday, up from 3.67 trillion yuan a month earlier.

Market participants said much of the recent foreign inflows to China bonds are currency hedged.

Though the yield differential between China and the U.S. remains wide, offshore investors found the returns of investing yuan bonds attractive when they use hedging instruments such as FX swaps to lock additional return.

Current USD/YUAN 1-year FX forward swap is trading at -2691 pips, implying an appreciation of the yuan against the dollar in a year. China's onshore bond return, adding up to the currency appreciation via FX swaps, makes total return more attractive than just holding U.S. treasuries.

As long as the U.S.-China yield differential remains wide, there will be incentives for such swaps, said Gary Ng, Asia Pacific senior economist of Natixis.

The interest rate gap between China 10-year government bonds and their U.S. counterparts stood at 192 basis points on Friday.

The shrinking rates differential between the U.S. and China is likely to slow domestic capital outflows and encourage foreign inflows, Ju Wang, head of Greater China FX & rates strategy at BNP Paribas, wrote in a note.

"It also signifies a decline in corporates' hedging costs, which, in turn, encourages corporates to hedge," Wang said.

With China's 10-year government bond yield hovering near a two-decade low, the country has less room to cut rates than the U.S. does.

China's central bank left a key policy rate


as expected on Sunday when rolling over maturing medium-term loans, with uncertainties around the timing of an easing by the Federal Reserve limiting Beijing's room to manoeuvre on monetary policy.

($1 = 7.1979 Chinese yuan renminbi) (Reporting by Beijing Newsroom and Shanghai Newsroom, Editing by William Maclean)