The versatile 23-year-old becomes new Sky Blues boss Mark Robins's fourth addition since taking over at the struggling League One outfit last Wednesday, following in the footsteps of Conor Henderson, Jamie Reckord and Franck Moussa.
Robins said: "James has a lot of qualities and we believe he will be a good addition for us as he can play in a couple of positions and is a very good passer of the ball.
"Not only that, he will put his foot in and will land on second balls too. I've seen a lot of him over the past 18 months to two years and we are looking forward to working with him."
Bailey, who will be available to make his debut in Coventry's Capital One Cup third-round clash at Arsenal on Wednesday night, started his career at Crewe before moving to Derby in the summer of 2010.