Can somebody explain the part in bold? It looks counter-intuitive to me. Shouldn’t yields increase (as opposed to decrease) sharply?
As demonstrated by the Greek exit crisis, however, the situation changes sharply when the market perceives an imminent threat of devaluation (or withdrawal from the common currency). Spreads then widen throughout the curve, but especially at the shortest maturities, and the curve will almost certainly invert. Why? Because in the event of a devaluation, yields in the devaluing currency will decline sharply (as the premium-risk currency collapses), generating much larger capital gains on longer-term bonds and thereby mitigating more of the currency loss.”
The problem lies between short-term and long-term yield.
According to uncovered interest rate parity, the short-term rate of the devaluation currency would increase. While based on the overshooting mechanism, over long-term, the devaluation currency is expected to appreciate. Hence, the long-term rate will decline, leading to the inverted curve.
If you’re holding bonds in a currency that is about to be devalued, your total return (yield on the position) declines. Hence to reflect this risk, holders sell off the bonds, and potential buyers will not pay the same price (especially the short-term bonds, which are the most at risk), which leads to a spike in short-term bond yields. Due to more risk in the near term, yields (just the typical bond price decline) spike in the short end of the curve relative to lesser spikes at longer-term maturities. This creates the yield curve inversion. Remember, an inverted yield curve means investors view more risk in the near term than the long term. (Illustrated by demanding a higher yield/risk premium)
From how I see it, the confusion comes from the term ‘yield,’ which usually means the bond price + coupon (YTM). However, in this context, I think by ‘yield,’ they refer to the return, including the currency movement.
Let me offer an oversimplified example: let’s say you(the foreign investor) think of buying a 0% coupon bond for par, so you are expecting a 0% return. If you’re a foreign investor and your home currency and the bond’s currency are pegged to each other, then you will expect a 0% return (the currencies should move in tandem). Now, with 2 months to maturity (to receive the $100 principal), you expect the peg/link to break and the bond’s currency to decline by 5%. Now, you’re in a situation where if you buy it for par, hold it to maturity and convert it back to the home currency; you’re going to be at a -5% loss. Therefore you (the investor) will need to buy it for $95 to make the expected 0% return. In the bond’s home currency, the short-term bond’s yield just spiked by 5%.
Long-term bonds do not see an equivalent % spike in yields because they have more cash flows being discounted at a now higher interest rate (which is derived from the shorter end of the curve and includes the additional long term credit risk premiums), which reduces the PV of the bond and will allow the investor to capture a larger capital gain in the future.