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For an investor in the 35% tax bracket, income from municipal bonds that was tax free would effectively be taxed at 7% after January 1, 2013.

My colleague Peter Hayes, head of the BlackRock Municipal Bonds Group, weighed in on Obama’s proposal, saying in a paper that the probability of the bill’s passage was unlikely. “However, the very fact that the proposal exists does thrust tax exemption onto the legislative table like never before, and there is a high probability that tax policy could be much different 15 to 18 months down the road,” he said.  His piece also talks through what the news might mean for municipal bond yields and some of the math of how investors’ after-tax yields could be impacted. For municipal bond investors, he added that “vigilance is warranted given the new focus on tax exemption, but panic certainly is not.”

President Obama has called for lawmakers to vote on the plan this month, but Congress has been divided on the proposal since it was unveiled. Senate Democrats have scheduled a key vote on the bill for Tuesday, although they are not expected to get enough votes to pave the way for the bill’s passage.

Where does this leave muni bond investors? I would agree with Peter that in this case vigilance is warranted, but panic is not. Munis are generally viewed as a low-volatility, stable asset class that can help investors preserve capital while generating income. I would advise investors to keep an eye on the asset class as the debate progresses and determine how best munis could fit into an overall investment portfolio, taking into consideration your tax bracket.

Since Obama introduced his plan on September 8 muni bond yields have remained relatively flat though they have lagged Treasury yields, which have rallied over that time. With the markets concerned about US growth and the resolution of the European sovereign crisis US Treasuries have actually outperformed most other asset classes. Comparing municipal bond performance to comparable quality US credit bonds can be a helpful way of understanding what has been happening.

The chart below shows the yields of each asset class as a percentage of similar maturity US Treasuries. An increase in the level indicates the asset class is underperforming Treasuries, as we have seen in both AAA Credit and AAA municipals over the past few months.

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Barclays Capital:

Bloomberg:

Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise. A portion of a municipal bond fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.