in the xml file of course don't appear in my transformed output.

why "of course" ??

The default behaviour of xslt is to copy character data
so if it isn't being copied you presumably have a template that is
explictly not copying it.

Again do you really have

<!DOCTYPE holdspace [<!ENTITY nbsp "& n b s p ;">]>

or has your mailer changed & # 1 6 0 ; to nbsp.
As shown your entity file is defining nbsp to be nbsp.

David

<!DOCTYPE holdspace[<!ENTITY nbsp "&nbsp ;">]> <--no spaces &nbsp;
when I view this xml file I see <OBJECT>&nbsp;</OBJECT>