Dubai's flagship investment vehicle is in talks with banks to launch its first Islamic bond, three sources with knowledge of the matter said, tapping improved sentiment towards the emirate in a bid to diversify its funding sources.

Although talks are at an early stage, Investment Corporation of Dubai (ICD), which controls some of Dubai's top companies, expects to complete a deal this year, one of sources said.

ICD is taking advantage of increased demand for Dubai debt, which has benefited from international investors seeking emerging market assets, but also improved sentiment driven by a recovery in the local economy and state-linked debt restructurings.

Dubai's five-year credit default swap, an indicator of how likely a borrower is to miss debt repayments, dropped in the year to February 21 to 222.4 basis points from around 400 basis points, according to Thomson Reuters data.

Last month Dubai attracted over $9 billion in bids for a $750 million, 10-year Islamic bond (sukuk).

This came three years after state-owned conglomerate Dubai World announced a $25 billion debt restructuring, triggering a debt crisis which affected billions of dollars of loans and a $10 billion bailout for the emirate from Abu Dhabi.

ICD has stakes in bluechip companies including Emirates airline, the bank Emirates NBD and Emaar Properties.

A source at ICD said the fund had no plans for a sukuk. Abdulrahman al-Saleh, director-general of the Dubai Department of Finance, declined to comment on the potential sukuk.

The fund is turning to the Islamic bond market because of potential legislation capping lending by local banks to government related entities (GRE), a source said.

While the rules, which limited GRE lending to 100 per cent of a bank's capital base, were scrapped in December, some bankers expect them to be resurrected, impacting some of the UAE's largest banks, which are heavily exposed to government entities.

"There has been a shift in thinking - they know they can no longer just say to banks 'give us money as we're Dubai' and banks happily hand it over," said the first source aware of the talks, who spoke on condition of anonymity.

ICD's board is headed by Dubai's ruler, Sheikh Mohammed bin Rashid al-Maktoum, with crown prince Sheikh Hamdan bin Mohammed al-Maktoum as vice-chairman.

Separately, ICD is also talking to bankers over a $2 billion loan due to mature in August, with refinancing the likely option, sources told Reuters earlier this month.-Reuters