A bond has a par value of $1,000, a time to maturity of 20 years, a coupon rate of 10% with interest paid annually, a current price of $850, and a yield to maturity of 12%. Intuitively and without using calculations, if interest payments are reinvested at 10%, the realized compound yield on this bond must be

The answer is:

Lower than 12%

Explanation:

The realized compound yield on this bond must lower than the initial yield of 12%

This lead to what will call reinvestment risk. Reinvestment risk is more likely when interest rates are declining (going down).

When interest rate declines, an investor loses money because the real value of the money or fund will be reduced. And reinvesting the money that was initially at 12 percent interest rate will be lower.