For your overlay image, what size/dimensions is it? It should be at least the same size in pixels as your video. It's always best to resize image files in photo editing software, as they are designed for that, they just do a much better job than VS. Next since you mention the
black bars, those are common when creating panoramic videos, or wide-screen, 16:9 video. The video editor will mask top and bottom portions of the video or images to fit that aspect ratio.
In your Project Properties does it show the aspect ratio of 16:9 or 4:3? If so make sure any images match that aspect ratio. Have a look at this quick read article about ratios
Understanding Video Aspect Ratios
There is an option in the Preferences for VS where you can elect to have the resampling to keep the aspect ratio with no letterbox. When aspect ratio becomes a concern, the program can either apply Letterbox or Pillar to mask the areas falling outside the screen.
The second screenshot you provided is not so much pixelated, as it is just distorted. The first image is showing a different aspect ratio, as the second. Please select Project Properties from within VS, then copy them to this thread. Do the same with the video clip, using VS not the OS (Windows) method of selecting properties. This is done by right-clicking on a video clip, select properties. I'd guess that you are using a 4:3 aspect which is almost square. So VS will distort your image. You can with the overlay image selected, right-click on the preview screen to get a menu of options. Select
Keep aspect ratio, then fit to Height or Width. How about applying a pan/zoom to your image? That can help in this type of situation too.
