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By Bloomberg

East Lodge Capital Partners LLP is buying protection against losses on U.K. government debt and the pound before the Scottish independence vote in two weeks' time, according to a person familiar with the matter.

The London-based hedge fund run by Alistair Lumsden has also taken short positions in Royal Bank of Scotland Group Plc, betting the stock will decline in value if Scotland calls time on the nation's 307-year-old union with England and Wales, said the person, who asked not to be identified because the information is private.

As Scotland's independence debate enters its final days before the Sept. 18 ballot, opinion polls show the No camp's lead is narrowing with enough undecided voters to cause an upset victory for the Yes side. With the nationalists saying the momentum is behind them, Goldman Sachs Group Inc. said the U.K. could fall into a euro-style crisis if Scots vote for a split.

"If the Scots were to vote yes, the uncertainty around the U.K. would impact everything from the pound to gilts," said Hans Lorenzen, a credit strategist at Citigroup Inc. in London. "That uncertainty would also be felt in credit-default swap spreads."

Karyn Geringer, a spokeswoman for East Lodge in New York, declined to comment on the company's trades.

The hedge fund bought credit-default swaps that protect against losses on gilts, the person familiar with the matter said. The hedge fund is betting the cost of the contracts will increase because a Scottish breakaway would deepen concern about how government debt will be treated.

Swaps Cost

A total of $5.4 billion of U.K. government bonds were covered by swaps as of Aug. 29, according to the Depository Trust & Clearing Corp. That's down from $5.8 billion in February and compares with $11.6 billion for Germany.

A YouGov Plc poll for the Times and Sun newspapers published this week showed an increase in support for independence with the No lead narrowing to six percentage points. Among men, the nationalists had overtaken and showed a lead of two points while among women the deficit was 13 points.

Scottish National Party Leader Alex Salmond yesterday challenged Prime Minister David Cameron to find arguments why Scotland should stay in the union. Cameron warned the nationalist threat to default on government debt if an independent Scotland isn't allowed to use the pound would lead to much higher debt costs for households and businesses.

Pound Volatility

Salmond has refused to give up the pound and said in an Aug. 25 televised debate that the SNP had three currency options for an independent Scotland if the U.K. persists in its refusal to let it use the the currency.

Investor concern over the effect on the pound of an independent Scotland is increasing volatility in sterling. A gauge of future price swings for the U.K. currency against the dollar saw the biggest one-day jump since October 2008 earlier this week.

East Lodge has bought put options on the pound that benefit if the pound weakens, the person familiar said. The pound fell 0.04 percent to $1.6454 at 9:07 a.m. in London, the lowest level since February.

The cost of insuring U.K. debt has dropped to 19.5 basis points from 28 basis points at the start of the year, according to data compiled by Bloomberg. That's the fourth lowest among 133 governments tracked by Bloomberg, after the U.S., Sweden and Norway, which costs 12 basis points.

There were 17 trades last week, covering a gross $446 million of U.K. debt, DTCC data show. That compares with seven trades covering $231 million of German debt.

Direct Lending

Lumsden started East Lodge in April with $250 million of assets under management to focus on asset-backed securities and direct lending. The hedge fund's has since grown to $500 million and has returned more than 8 percent since it started trading, the person said.

Lumsden was the chief investment officer of hedge fund CQS U.K. LLP's $2.3 billion ABS fund, which he led to a 73 percent gain in 2008 when he bet against subprime mortgages and the banks that loaded up on them. The CQS ABS Fund gained an average 28 percent annually when Lumsden ran it from October 2006 through November 2012, according to a note to clients.