Nakheel, Dubai’s leading property company and owner of the Palm development, offshore of the Gulf city, is in talks with Dubai World, its heavily indebted parent, over the repayment of a $3.5 billion (£2.1 billion) Islamic bond.

Dubai World, which also owns DP World, the world’s No 3 port operator, is guarantor of the Nakheel bond, which is being watched closely by Islamic investors as a bellwether for the shaky finances of the city-state and the health of Islamic finance, generally. Dubai World is the investment holding company of a clutch of emirate-related businesses that have huge debts. Dubai has to refinance $50 billion of maturing borrowings by 2013. Dubai World is believed to owe $60 billion.

In an effort to keep the State’s business ventures afloat, the Dubai Government this year raised an emergency $10 billion loan from the central bank of the United Arab Emirates.

Talks over Nakheel’s sukuk, an Islamic financial bond, which matures next month, are taking place as Dubai’s ruler castigates the Emirate’s critics. They point to strained relations with Abu Dhabi, its richer, but more conservative, neighbour, which has been forced to step in, using its vast oil wealth to guarantee Dubai’s huge property debts.

Sheikh Mohammed bin Rashid al-Maktoum insisted this week that there was no tension between the two emirates. “There is no Dubai and Abu Dhabi, we are one ... I want to tell those people who who nag about Dubai and Abu Dhabi to shut up,” he said.

Dubai’s bubble economy of property and hotels came a cropper in last year’s financial crash. Speculators and migrant workers fled the emirate, many abandoning cars, flats and credit card debts in a rush to escape punitive bankruptcy laws. In November last year, the United Arab Emirates Government, backed by the oil wealth of Abu Dhabi, stepped into the breach, promising to stand behind Dubai’s borrowings that exceed the state’s GDP.

In the wake of the financial crash, concern is now mounting over the region’s trilliondollar market in Islamic bonds.

Troubled investments and a series of defaults, including Saad Group and Investment Dar, a Kuwaiti Islamic investment fund, in April, have focused attention on the obscure and untested legal structure of Islamic bonds.

The Gulf’s oil, property and finance boom helped to launch the market in sukuk, a form of bond that complies with Sharia (Islamic law) strictures that prohibit the payment of interest on money. Islamic financial institutions have devised a variety of structures using techniques, such as sale-and-leaseback, to get round the prohibition.

Typically, Islamic banking seeks to structure interest as a profit-sharing venture but, according to Neale Downes, a partner at Trowers & Hamlin, the law firm, in Bahrain, there is confusion over the legal protection offered to holders of sukuk.

In some cases where sukuk issuers have become insolvent, Mr Downes said that “investors have found themselves unexpectedly competing with the general body of creditors, rather than simply enforcing against or taking possession of assets supporting their sukuk”.

The outcome of negotiations over the Nakheel sukuk will be key to the future of the Islamic bond market, which has been rocked by a series of defaults.

Investment Dar, which owns half of Aston Martin, the British luxury car company, failed to make an interest payment in April on a $100 million sukuk issue. Investment Dar’s default followed one at Global Investment House, another Kuwaiti investor.

In June, $650 million of Islamic bonds issued by Saad Group, the investment company controlled by Maan al-Sanea, which owns a stake in HSBC, were downgraded to default status.

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