Heterochromatin maintains genome integrity and function, and is organised into distinct nuclear domains. Some of these domains are proposed to form by phase separation through the accumulation of HP1ɑ. Mouse heterochromatin contains noncoding major satellite repeats (MSR), which are highly transcribed in mouse embryonic stem cells (ESCs). Here, we report that MSR transcripts can drive the formation of HP1ɑ droplets in vitro, and modulate heterochromatin into dynamic condensates in ESCs, contributing to the formation of large nuclear domains that are characteristic of pluripotent cells. Depleting MSR transcripts causes heterochromatin to transition into a more compact and static state. Unexpectedly, changing heterochromatin’s biophysical properties has severe consequences for ESCs, including chromosome instability and mitotic defects. These findings uncover an essential role for MSR transcripts in modulating the organisation and properties of heterochromatin to preserve genome stability. They also provide insights into the processes that could regulate phase separation and the functional consequences of disrupting the properties of heterochromatin condensates.