Iraq's sovereign bond yields are likely to creep up as the world's 11th largest oil producer heads to a January vote, but if the poll goes well, yields will return to tracking oil prices, production and global markets.

Risk appetite is returning to emerging markets as the global economy recovers and support for the markets from multilateral lenders kicks in. The recovery has fed into a better performance across the board for emerging markets.

Iraq is gearing up for parliamentary elections next year that will be seen as a crucial test for its nascent democracy, and the poll will be keenly watched by investors and oil majors striking deals to tap the world's third largest oil reserves.

"There is scope for political noise and statements to undermine sentiment and affect the bond price. That might be a transitory thing," said Stuart Culverhouse, chief economist at frontier markets brokerage Exotix.

"After the election, if there was some sense that it was durable, then the attention would begin to focus on the oil prospects, oil prices and production."

Iraq sold a $2.7 billion global bond of restructured commercial claims in 2006, which were left over after the ousting of dictator Saddam Hussein in 2003 by US-led troops. The bond matures in 2028, has a 5.8 per cent coupon and starts paying back principal from 2020.

The eurobond's yields spiked in late 2008, hitting around 16 per cent on the back of fallout from the global financial crisis, but have since come back down to around nine per cent.

In Iraq, instability has largely deterred foreign investors, except in the oil sector, but a drop in violence in the last two years and prospects of a more inclusive election should ease some fears. Bloodshed, however, remains common.

"Obviously with the election, we wouldn't be surprised to see some noise," said Edwin Gutierrez, portfolio manager at Aberdeen Asset Management, which holds Iraqi debt. "I'm not as focused on the violence as it doesn't seem to be sectarian."

After decades of a state-dominated economy under Saddam Hussein, Iraq is trying to deepen its financial markets, break Saddam's debt burden and rebuild its shattered economy. But Iraq's fundamentals, like under Saddam Hussein, are still driven by oil.

Iraq is close to clinching a raft of deals with oil majors for prized oil and gas fields. Crude oil deals stand to catapult Iraq to the world's third largest oil producer, fill government coffers with petrodollars and boost investor confidence.

Baghdad plans to auction more fields in December.

Besides the eurobond, Iraq has said it wants to issue local Treasury bonds to try to fund its 2010 budget deficit.

The illiquidity of Iraq's financial markets and tax issues will remain an impediment to luring foreign investors to Iraq's nascent local debt. Baghdad has no secondary market despite having the infrastructure at the stock exchange, players said.

"There's definitely an attractive opportunity there. The main thing will be access, getting in and getting out," said Francis Beddington, head of research at the fund Insparo.

Pricing of local bonds will also be key to attract investors outside of Iraq, and yields will probably need to be in high single to low double digits to be attractive, Culverhouse said. "There is demand. They just have to get the pricing right."

Forgiveness of Saddam-era debt has bolstered Iraq's outlook. The Paris Club has forgiven around 80 per cent of Iraq's debt, and Baghdad has settled claims with dozens of other countries.

Iraq and the International Monetary Fund are in talks for an IMF-funded programme, which would signal confidence in Baghdad's economic plans as it courts foreign investors.

"Improved oil production and a rebound in global oil prices will help to service this Saddam-era debt and any new debt caused by expansionary fiscal policy and aggressive post-war re-development," said Brad Phillips of IHS Global Insight.

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