Heavy rain pounded Dubai on Sunday adding to the gloom of the emirate's debt woes a day before the deadline of the $3.52 billion bond by state-owned developer Nakheel, with no word on how it will be handled.

Dubai's stock market did soar for a second consecutive session on Sunday as traders reacted to a surge in Nakheel's bond price last week on mounting speculation it will repay.

The Islamic bonds, or sukuk, had been trading around 110 cents to the dollar before the government shocked investors on November 25 with a request for a six-month standstill on the debt of state-linked Dubai World.

The announcement sent the sukuk down to mid-40 lows, but closed on Friday at about 54 cents to the dollar.

Fund managers and bankers regard Monday's outcome as the litmus test for Dubai World's planned $26 billion restructuring and Dubai as a whole for resolving its debt burden.

But the odds of Nakheel, the developer of palm-shaped islands, repaying are low.

It's very hopeful people (speculating), says a Dubai-based fund manager. It seems very strange that if Dubai World intended to pay they would have gone through the last two weeks of pain.

A sudden u-turn and repayment would placate disappointed and confused investors in the immediate term. Dubai's handling of the situation has tarnished its reputation.

Dubai's finance chief on Thursday tried to reassure investors saying its actions were more important than its public image. But, Dubai World has few options.

The key thing is the lack of clarity, said Nish Popat, ING's head of fixed income in the Middle East. What's needed more than anything else is some sort of information to understand what the plans are going forward and how they are progressing.

Reflecting rising repayment hopes, five-year credit default swaps for Dubai fell more than 30 basis points on Friday to 533 basis points, according to CDS monitor CMA DataVision, compared with a peak of almost 700 bps at the end of November.

The level is still high given the CDS was quoted at about 300 bps before the November 25 announcement.

The CDS spreads are better, and news of a hedge fund buying into Nakheel - this is all positive ... even if you buy Nakheel at 50, and they pay out 70, you're still making good money, said a banker from a Dubai government-controlled lender.

If Nakheel does not pay on Monday, it would technically be in default, but it would still give its restructuring team a two-week grace period to reach an agreement with creditors.

December 28 is the final cut off point. After that a cross default clause in its original prospectus will be triggered that covers Nakheel and its guarantor Dubai World, adding to the overall debt burden.

Regional markets have been struggling for weeks under the issue.

Prices are so distorted right now, said Haissam Arabi chief executive at Gulfmena Alternative Investments. Tomorrow is a big day, until we get some clarity (about Dubai's debt) there will be no real trend. The main catalyst we are waiting for is Nakheel news.

STRIKING A DEAL

Analysts have speculated Nakheel could repay its bond at 70 cents to a dollar and issue new debt for the remainder.

Such an outcome would be beneficial for both parties involved, EFG Hermes analyst Fahd Iqbal wrote in a research report. Creditors would receive a portion of their money back with a promise for the remainder to be delivered at a later stage while Dubai World, along with other government related parties, would have continued access to capital markets.

With time running out for a deal on Nakheel's bond, bondholders may have to accept some impairment, leaving Dubai World free to negotiate with longer-term debt holders.

But vociferous minority holders of Nakheel's bond are still demanding repayment, which could lead to potentially damage larger claims.

The third option is for Dubai World to outline details of its restructuring plans and announce a standstill agreement with its creditors. This would make Nakheel's bond date irrelevant in the grand scheme of things and buy valuable time for Dubai.

It would bring confidence if there is a settlement of good faith or they restructure or they pay, but the rest will linger as there is debt outstanding to corporates, contractors and all kinds of creditors, said John Sfakianakis, chief economist at Banque Saudi Fransi-Credit Agricole Group in Riyadh.

Dubai's government and affiliated firms owe non-financial Japanese companies roughly $7.5 billion in credit that had not been collected as of October 31, a study by Japan's government showed.

In addition, fears that Dubai's debt problems are not limited to the state-linked firm has already battered investor confidence. In February, Borse Dubai has $2.5 billion of debt maturing, while Dubai ruler's own firm Dubai Holding will face almost $1.9 billion of debt repayments in the first half of 2010.

There is no precedent for such a situation in the region - tomorrow is D-Day, said one banker.

(Reporting by John Irish; additional reporting by Rachna Uppal and Nicolas Parasie; editing by Inal Ersan and Simon Jessop)

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