DUBAI  - Saudi Arabia's sovereign wealth fund started taking orders for its debut dual-tranche Islamic dollar bond on Wednesday, in the first major test for Middle East markets since the sharp escalation of the Israel-Hamas conflict.

The Saudi Public Investment Fund (PIF) gave initial price guidance for the bonds of 150 basis points over U.S. Treasuries for its five-year tranche and 170 bps over the same benchmark for the 10-year tranche, banking documents showed.

PIF's Islamic bonds drew over $12 billion in demand, excluding interest from lead managers, a second bank document followed.

"They’re looking pretty attractive from an investor’s point of view. For PIF, they probably are looking at higher costs given the current conditions," a fixed income analyst said, taking into account that final pricing is often less generous.

The sale is seen as a key test of investor appetite for Middle Eastern bonds, after the Oct. 7 attack on Israel by Hamas and subsequent response from Israel.

Saudi sovereign spreads - or the premium investors demand to hold its bonds rather than those of the United States - have widened by around 15 basis points so far this month.

Major investment banks such as JPMorgan and Morgan Stanley have downgraded their view on the broader region due to the still-escalating conflict.

The PIF is the chosen vehicle of Saudi Crown Prince Mohammed bin Salman, the kingdom's de facto ruler, to drive an economic agenda aimed at cutting reliance on oil.

The planned issuance will be PIF's second international debt issue this year after it raised $5.5 billion from green bonds in February.

The wealth fund has raised tens of billions, including a $17 billion loan in November, to fund a mammoth investment programme to create new industries and jobs, including building a planned futuristic city in the desert known as NEOM.

This year, the government transferred a 4% stake in Saudi Aramco worth $80 billion to the PIF, which it said was aimed at bolstering the fund's financial position and high credit ratings.

The PIF had $85 billion in loans and borrowings at the end of 2022, its annual report released in July showed, an almost 30% increase from end-2021.

It took an $11 billion hit on its investments in 2022, a year after posting a profit of $19 billion.

(Reporting by Hadeel Al Sayegh and Yousef Saba in Dubai, Mohammad Edrees in Bangalore; Editing by Alex Richardson, Bernadette Baum, Christina Fincher and Louise Heavens)